Borrowing for Your Franchise

In my previous post, I listed four financial skills that I think every franchisee — frankly, every business owner — should have. In this post, I will talk about the impact of borrowing to finance your franchise. It is imperative that franchisees understand the impact borrowing can have on cash flows.

If you have to borrow a substantial amount to get your business up and running, you will also have to service the debt. One of the most common financial complaints I hear from franchisees who are struggling is that they aren’t making any money even though the profit and loss statement shows healthy income. This is usually because they borrowed so heavily to start the business that most of the cash flow is going to service debt payments. This is not necessarily a bad thing if you understand what you are doing and you have planned accordingly. If the business cash flow can service the debt, you are potentially getting a great return on your investment. Let’s look at a simple example:

Becky Borrower needs $400,000 to open a Bob’s Burger Barn (BBB) franchise. She borrows $300,000 for 5 years at 10% interest. Her monthly debt payment is just over $6,300. If her BBB franchise generates $500,000 in sales and profits of $100,000 (20%), she will only net about $23,000 after debt and before taxes. It doesn’t sound good.

On the other hand, Becky Borrower only invested $100,000 and generated a return on that investment of roughly 23%! And if we assume that the business is worth more or less what Becky paid for it, then she is in pretty good shape as long as she planned for the debt payments and doesn’t need the cash flow for living expenses.

Let’s compare Becky Borrower to Calvin Cashpayer. As his name would suggest, Calvin paid all cash for his franchise. He generates the same results ($500,000 in sales, $100,000 in profits). Since Calvin Cashpayer has no debt service, other than taxes and depreciation, his income is going to be a lot closer to his cash flow. Interestingly, his return on investment is actually slightly lower than Becky’s. He invested $500,000 and generated $100,000 for a 20% return. If Becky had negotiated a lower interest rate (say a 6% SBA loan), she would have seen a pre-tax return of almost 30% on cash invested and still she wouldn’t have a lot of cash in the bank.

I mention this because in my experience, Calvin Cashpayer would be thrilled with the business and Becky Borrower would be ticked. Becky is actually getting a better ROI but franchisees in highly leveraged situations usually didn’t plan to service the debt they needed to invest in the franchise.

There isn’t a right way or a wrong way to do this. Borrowing can be the right decision, but only if you plan to service the debt and understand that it will have a significant impact on your cash flow.

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Franchise Finance Basics

In my role at Franchise Foundry, I often have the opportunity to speak to franchisees about their financial statements. Financial management is a skill that is critical to successfully managing a franchise, but it is common for franchisees to have limited financial backgrounds. Their franchise may be the first time that they needed to be able to read a profit and loss statement. While I can’t cover everything you need to know to manage the finances of your business, here are three tips that most people I talk to would benefit from:

1. You can only manage what you measure.
When times get tough, it’s human nature to put your head in the sand. When you start managing your finances by what is in your checking account, you will find that there is less and less in the account. Even if times are tough (maybe especially if times are tough) pay close attention to your financial statements.

It is also important for your financial statements to be accurate. If you have a lot of expenses labeled as “Miscellaneous” or “Credit Card Charges” you won’t be able to get a handle on where your money is going. Knowing where your revenue is coming from is important too. If you have a few categories of revenue (food and clothing, for example) make sure that you break that out as well.

2. Know the difference between fixed and variable expenses.
Fixed expenses stay the same every month and variable expenses change depending on how much you sell, how much labor is required, etc. You typically have one shot at negotiating your fixed expenses (when you negotiate your lease, for example), but you can often work on reducing your variable costs over time. When you are starting a business, do what you can to keep fixed costs as low as possible. Low fixed costs means you have a lower break-even point — the point at which your revenues cover all of your expenses, but you make not profit.

3. Don’t mistake profit for cash flow.
I can’t tell you how often I have heard people say, “The profit and loss statement says I should have $XXXX, but there is no money in my checking account!” Make sure you are asking your accountant for a complete set of financial statements. This should include a profit and loss statement, a balance sheet, and a statement of cash flows. There are online tutorials that will teach you the basics of each of these documents, but for the purposes of this blog, I will tell you that the statement of cash flows will tell you if you generated cash this month or not. The profit and loss statement is intended to give you a basic overview of the health of your business. The idea behind modern double entry accounting is that we want to match expenses with the revenues they helped to generate.

Let’s take a simple example. Let’s say you need a computer for your business and that computer will probably help you operate your business for 2 years. If you were to pay $2,400 for the computer equipment, your bank account would show you paying $2,000 but your profit and loss statement would probably show an expense of $200 per month for each month of the 2 year lifespan of the computer. You would also see an asset on your balance sheet that would decline in value as you recognize the $200 per month on your profit and loss statement.

4. Track expenses as a percentage of sales.
I like to look at my monthly expenses as a percentage of sales and then compare those to industry averages. Most franchisors will share information with you and let you know how you stack up compared to others. If your labor cost is 30% while everyone else’s labor is averaging 25%, you know where to focus your efforts. Look at these expense lines as a percentage of sales by month and year to date. It’s also useful to look at how you did last month compared to the same month last year.

Finally, it’s important to understand the impact borrowing can have on your cash flow. That topic is complicated enough to warrant its own post. I will write about that next.

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Funding Your Future Franchise

It’s no secret that the current economical climate has affected the franchise world for good and for bad. On the “good” side of the spectrum, people who have been content working for others are re-evaluating their professional options. If you own your own business, you have greater control of your future and are able to reap your rewards instead of passing them to your boss.

On the other side of the spectrum, you have the negative effects. This can be summed up in one word – funding. Across the board, getting loans and funding for anything from a home to a car to (of course) a business is harder than it has been for decades. However, that certainly doesn’t mean you should throw in the towel. If you’ve found a franchise opportunity that’s the right fit for you, then there are still ways to get the funding you need. Here are some things to remember as you start the process:

Choose the right franchise:
When you are looking at franchises there are a few things of which you need to be aware. If you’re going to be an owner operator, make sure you like the work. Talk to as many franchisees as you can. Be objective about what your return will be.

When it comes to funding, there are 2 very important things to look for:

SBA Approval:

If you are considering buying franchises, focus on those that are SBA approved.  The SBA approval increases the franchise’s legitimacy in lenders’ eyes and, generally speaking, makes it easier to find funding.

Franchisor Financing – Look for franchise concepts where the franchisor is willing to do seller financing on the franchise fee. This is becoming more common in today’s market, and it will help decrease the amount of capital you need upfront.

Be prepared:
Getting funding is not a casual matter. This means you have to get your act together before you start applying for loans. Too often people try to get funding before clearly identifying their financial needs, so one of our recommendations is to develop a strategy that includes several financing options.

Have a business plan in place, but also a finance plan – Who are you going to go after? Do you know how much you’ll need?  What are your pro forma projections? These are things that a good franchise system will help you get together. Knowing that information will save you time and increase the likelihood that you will get funding for your franchise investment.

Talk to other people who have raised money and ask them how they got it. What hoops did they have to jump through to get it? This may help you avoid major pitfalls and may also help you create the connections that can make all the difference.

Break it down

One thing to remember when buying a franchise is that the investment can be broken down into several categories. Rather than trying to fund the entire investment from a single source, you may want to consider funding the various parts of the investment individually. Your investment is typically broken down into categories such as franchise fees, real estate, equipment and other start-up costs. Here are some examples and breakdowns of how to go about securing funding:
Franchise fee – You should be able to negotiate seller financing with the franchisor, especially in this downturn economy. Franchisors are trying to sell more franchises and they’re probably willing to cut you a deal.

Equipment – Because this is usually a hard asset, this is something that is easy to get a loan against because it can be collateralized. You should try to get a lease agreement with the bank to finance that over three or four years.

Real Estate – With the downturn in the real estate economy, you should go to the owner of the building and ask for tenant improvements and ask for him to finance this portion of your start-up costs.

Choose the right lenders

Once you’ve found the right franchise, prepared a well-thought out business plan and broken down your costs, it’s time to find the money. There are many different types of loans and leaders you can appeal to.

Love loans:

These are loans from family or friends. It’s not unusual for a parent, grandparent, friend or neighbor to be willing to help you raise your needed collateral by investing in you. In fact, with the economy and job market on the ropes, many parents are buying franchises for their college graduate children to run. This provides their child a job with real business experience, while also receiving a better return on their investment than the current market could render.  Be forewarned, although these can be some of the easiest loans to get, they can be the most costly (in many different ways) if things take a bad turn.

Local Banks and Credit Unions: There is a lot of research highlighting ways the credit crunch has hurt big banks, but in most cases, local and regional banks haven’t been hit as hard. If you are a member of a local bank or credit union make an official presentation (see Be Prepared). Local financial institutions are much more likely to help local customers opening local businesses.  That being said, you go in expecting to have to give a personal guarantee.

State Programs:
A recent report by the IFA Educational Foundation determined that for every $1 million of lending obtained by franchised businesses, 34 jobs are created and $3.6 million in annual total economic output is generated. These are the types of numbers state and local leaders like to hear. Some states have special programs for small business owners to receive funding if they invest back into the community. Talk to your local representatives and see what options are available to you. 

Severance Package:

Some of you reading this might be looking at buying a franchise because you are out of work due to the massive number of layoffs happening across the country. If you have a severance package, use it to fund a franchise purchase. It might be the best investment you ever make.

Finding funding for a franchised business is still much easier than starting on your own, but there is still a lot of work that goes into finding it. The bad news is that franchise sales are down nationwide because of this. The good news is that this means that those who are able to find the funding are much less casual about their investment and more prone to success.

So, if you’ve found the right franchise, and you’re willing to work at it, you can find the funding.

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