by Philip Morrison
last updated 17/09/2020
What Can You Afford?
by Philip Morrison
last updated 17/09/2020
Before you start looking at any particular franchise, you need to know what’s possible. Philip Morrison explains how to evaluate your own financial position
One of the results of rising house prices is that many people are using the increased equity in their homes to realise a dream and fund them into their own business. Franchises are particularly attractive to first-time business owners as they can be in business ‘for themselves, but not by themselves’. Having an established brand, proven business systems and specific training and support are all compelling reasons to choose a franchise.
Buying any business is a big decision that often requires a significant capital investment secured over the family home. It therefore demands careful scrutiny of the financial risks involved, as well as other factors such as family support, time commitment, relevant experience, your aptitude for business and your people skills.
In this article, we’ll show you how to examine your personal financial capacity to determine the price range of franchise opportunities you can realistically consider, and how to evaluate the maximum price that you could afford to pay for a franchise. This is especially important if you are considering buying an existing franchised outlet; paying too much at the outset will affect your profitability and returns for a very long time.
To illustrate the points, we have created a theoretical case study of a prospective franchisee called Arthur Hunter.
What have you got?
The first step for any potential franchisee is to work out your personal equity or net worth so you can determine what franchise systems are realistically within your financial reach.
You can determine your personal equity by compiling a personal statement of financial position. This involves noting what you own – your large personal assets, such as your house or investment property – and deducting what debt you owe. The balance left over represents your personal equity. We suggest you only include assets valued at over $5,000.
In the example in figure 1, Arthur, our potential franchisee, and his wife Rochelle have a house which has a current market value of $600,000, a car which has a current market value of $20,000, a redeemable life insurance policy with a current value of $10,000, and savings of $25,000 deposited at the bank. The only debt in this example is a $360,000 mortgage secured over the house and no credit card debt or hire purchases. Subtracting the debt from the assets, the figures show that Arthur and Rochelle have a net worth (equity) of $295,000.
When Arthur seeks to borrow against this equity to purchase a franchise, the banks will value his assets a little differently. For example, the bank may allow a potential franchisee to re-finance only to a level up to 80 percent of the house’s value – this would be quite normal. The house has a current market value of $600,000, so the bank’s maximum figure would therefore be 80 percent of $600,000, which is $480,000. When you deduct the mortgage of $360,000, the maximum by which you could therefore increase your borrowings against the home would be an additional $120,000.
The $25,000 Arthur and Rochelle have in savings would also be considered equity/personal funds available for purchasing a franchise. Let’s say that, in this case, the car and the insurance policy are not taken into consideration for raising funds. This means that the total equity/personal funds that Arthur has available for the purchase of a franchise is $145,000 (ie. $120,000 + $25,000). See figure 2.
What can you borrow?
Now, as well as the $145,000 of equity/business funds that Arthur has available, he may also be able to take out a business loan, which will be repaid (‘serviced’, as the banks say) from the cashflow of the business itself. Well-established franchises often have preferential arrangements with one or more of the major banks.
Over-extending yourself is the single biggest mistake people make when buying a business, so a good rule of thumb is to have a minimum 50 percent equity – don’t borrow more than another 50 percent. From observation, franchisees with lots of borrowing are more vulnerable during tough times and struggle to be sustainable. Following this advice would give Arthur the ability to borrow an additional $145,000, making a total available of $290,000 (see figure 2).
However, Arthur also needs to allow for something called Working Capital – the money you need to have available on a daily basis to make routine payments and buy stock or materials (see a full explanation here). It takes most new businesses time to start generating real revenue, even with a strong franchise brand behind them, so Working Capital needs to be built into Arthur’s calculations from the start. In the example, Arthur has allowed $30,000 for Working Capital, so the total amount he has available to buy a business is reduced to $260,000.
It’s worth noting that how much people can borrow often depends on their specific circumstances, and can vary between banks based on their lending policies and risk assessment of different industries. In the current climate, although interest rates are at record lows, financial resilience to survive uncontrollable business disruptions also needs to be worked into any assessment.
For Arthur, the next step is to establish the minimum income he requires the franchise to generate to enable him to live comfortably day-to-day.
What do you need?
Figure 3 illustrates the personal expenses that Arthur and Rochelle expect to incur each year, based on current prices. This example also includes a provision to cover KiwiSaver. When you perform this exercise for yourself, be realistic; many potential franchisees underestimate the amount that they believe they can live on. Make sure you include food, utilities, clothing, holidays, repairs and maintenance, etc. Although it’s not shown in this example, some franchisees will rely on a spouse or partner’s income to cover some or all of these costs. If Rochelle is going on working while Arthur concentrates on the business in order to provide ongoing income and reduce risk, they should consider how secure her position is.
This example includes interest and principal repayments that would be due on the increased mortgage of $480,000. It shows that the couple require an after-tax income of $61,000 each year to live day-to-day and repay their increased personal mortgage, so the franchise business will need to generate a gross income of about $79,000 for the numbers to work.
Risk, reward and effort
However, just being able to pay the bills is not enough. Arthur is going to be investing money, time and his career in this business so, as with any investment, he should expect a return on those too. The return on the funds you invest in a business should be over and above the salary/wages you require. Also, it should reflect the risk involved: Government bonds tend to pay a very low rate of return, because there is almost no risk involved. Banks pay a slightly higher rate of interest as the risk is slightly higher. If you win big, Lotto pays a massive rate of return – but it’s statistically unlikely that you will, so the risk is massive. In buying a business, you should look for a return higher than that which you would get if you put the money in the bank, but a good franchise should offer less risk than setting up in business on your own. In business ‘for yourself but not by yourself,’ remember?
The return on investment you consider appropriate therefore depends on your assessment of the level of risk involved. You may be content with a lower return if you are mostly using your capital to buy yourself a job, or your primary aim is to build an asset worth selling for a capital gain at the end of your ownership – a strategy which requires different analysis. As personal circumstances vary, we recommend taking advice from a franchise-experienced accountant on the process of assessing an acceptable rate of return.
As for time and career prospects, any business owner will tell you that, at least in the early days, they worked harder and longer than they ever had when employed by someone else. You are therefore likely to invest many, many hours in establishing your business, often seven days a week at first. You must therefore also consider whether the potential return on any particular business will justify the time and effort you will put into it.
What will suit?
Armed with the figures that he has calculated above, Arthur knows that in his current situation the maximum he is able to spend on a business is $260,000, and he needs it to provide a minimum gross income of $79,120 – in addition to whatever rate of return on investment he and his accountant have decided is acceptable.
Of course, there are other possible options if Arthur and Rochelle are willing to consider them. They could sell their house and invest the lot in a business, or rent the house out and go to live somewhere cheaper. Either of these would make a significant change in their financial situation, although they are potentially high risk, high return strategies – and would require total commitment to the new business not just from Arthur but from his family, too. Again, good financial advice will help re-work the figures accordingly.
Whatever Arthur decides, he is now in a position to consider franchises that suit his financial situation. Of course, it’s important that he also chooses something that he will enjoy and which will provide the training, support and market positioning that will help his business succeed (see the list of 250 Questions to ask Franchisors). The next stage is to start getting financial information from his chosen franchises.
Understandably, franchisors will want to know that a prospective franchisee is serious before they start parting with detailed financial information about their business model. They will therefore want to know that Arthur is a suitable candidate (and Rochelle, if she is going to be working in the business) and in a position to fund the franchise, so they’ll need to see the above information first. They will also probably want Arthur and Rochelle to sign a confidentiality agreement ensuring that they will only show any figures to their professional advisors.
Something to be aware of is that any figures provided are only forecasts based upon the franchisor’s model and experience in other locations. Although an experienced franchisor should have a good knowledge of the real costs of running the business, they can’t know for sure what level of sales will be achieved in any area before that business opens.
The figures provided will not therefore make representations, warranties or guarantees of performance, so they are only a starting point for further analysis. As a potential franchisee, it’s up to you to determine the assumptions on which the forecasts are based before placing any reliance on them. This reinforces how critical it is to seek independent assessment of the numbers from a franchise-experienced accountant who has benchmarking data based on like-for-like business performance.
Of course, if Arthur looks at buying an existing franchised business, there will be specific data available for analysis (see Understanding the Numbers). However, care must still be taken to ensure that the figures provided by an outgoing franchisee are realistic and accurate.
Three simple steps
If, like Arthur and Rochelle, you want to get into a business of your own and are starting to think about what you could afford, following these simple steps will help you be realistic right from the start.
1. Work out your own financial position as accurately and as honestly as you can.
2. Establish the income that you require from the business to meet your current commitments, and add a reasonable return on your investment.
3. Carefully consider the projections for the potential opportunity.
In my next article, I look at the sort of information that Arthur might receive about a franchise, and how he and his accountant might test the assumptions made and look at the impact different performance figures might have on the prospective business.
Remember, you don’t have to do all this on your own – in fact, you shouldn’t try to do it all on your own. Seek the advice of a specialist franchise-experienced accountant to help you evaluate the opportunity, review the projections and provide you with an independent opinion. Although every successful franchisee will tell you that they are passionate about their business, profit counts more than passion when you’re still considering which franchise to buy.
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