In most instances, the establishment of a franchise calls for a substantial investment. Individuals able to fund this investment entirely from their own resources are the exception rather than the rule but fortunately, appropriate funding mechanisms exist. Accessing them is a different matter altogether, but as you will see, as a franchisee of a reputable franchisor, you enjoy a head start. What does this mean in practical terms?
The first thing you need to understand is that there is no shortage of money for start-up finance.
Think of it this way: for bankers, money is “stock in trade”. They accept deposits from investors and pay them interest; unless they lend the money to borrowers at a higher rate of interest, they will soon go out of business.
What is in short supply, however, are entrepreneurs who are willing and able to present financiers with a well thought out funding application and business plan. There is also the thorny issue of “own contribution” and “security”.
Let’s look at these concepts in detail:
Newcomers to the business world will learn the hard way that to ask a banker for a sum of money, calculated arbitrarily based on a rough estimates of funding needs, is unlikely to secure them a loan. The banker must balance his desire to grant loans with his obligation to ensure that the bank’s funds, which belong to its depositors and shareholders, are repaid on time and with interest.
This means that unless you are able to make a meaningful contribution from your own resources and offer reasonable sureties for the balance, the banker may not be able to approve the loan.
There are few reasons for this:
- Having accumulated some cash of your own is an indication of your ability to handle financial affairs well.
- Should loan capital be the only source of finance, the cost of capital (interest) is likely to place undue strain on the business’s cash flow. This could strangle the viability of a sound business.
- Unless you as the borrower have a meaningful stake in the business, your commitment could be suspect. Should the business hit a rough spot, it would be all too easy for you to give up and walk away.
For these reasons:
- Your own business needs to be funded through a mix of:
- Equity (own capital), and;
- Loans (borrowed capital)
Inevitably a loan needs to be secured. However, qualifying applicants have access to various mechanisms that help in this regard.
There are 3 Types of Franchise Funding
To be able to present the banker with a well thought out funding proposal, you need to understand the various types of funding available and their respective advantages and disadvantages.
1. Equity Finance (Own Capital)
4 Types of Equity Finance
- Own Cash Resources
This has been mentioned already and is an absolute prerequisite. You cannot expect outside funders to advance you money unless you are willing and able to contribute some cash of your own.
- Soft Loans
You may be able to borrow some cash from family or friends who want to help you turn your dreams into reality. To qualify as soft loans (also known as off-balance sheet financing), such loans need to be unsecured, open-ended (no fixed repayment date has been set) and possibly even interest-free. You need to keep in mind that should the business venture fail, the chances of the grantors of such loans to receive anything back would be slim to non-existent.Although this is an informal loan agreement, it would be advisable to enter into a written agreement drawn up by an attorney. This agreement should set out the terms of the loan, and the rights and obligations of the parties. Should you fail to do that, the lender may, for example, decide to ask for his money back at a time when the business’s cash flow cannot support this request.
- Taking Partners on Board
You could invite others to join you in the venture, in exchange for a share in the business. The vehicle for such an arrangement could be a partnership, a CC or a limited company. Taking in partners has the added advantage that you can share the burden of building the business. Should you decide to go this route, however, you need to select the individuals involved with care, or your life could be difficult. It is especially important that your future business partners share your vision for the business. This is non-negotiable. If they also bring complementary business skills into the business then it could well turn into a match made in heaven.
- Joint Venture Arrangements
Some franchisors are prepared to enter into joint venture arrangements with suitable individuals. At the outset, they take a large share in the franchise, thus reducing the amount of cash you need to invest. Such an arrangement makes it also easier for you to access loan capital because the banker knows that the franchisor has an extra incentive to ensure the business’s success.If you can convince the franchisor of your choice that you are a joint venture partner of exceptional calibre, you may be able to negotiate a deal to the effect that you make your initial contribution in the form of “sweat equity”. This means that instead of investing cash, you work in the franchise, usually at a nominal salary. The shares in the franchise company are held in trust, pending payment. Profits generated in the franchise are allocated towards this until eventually, you own the franchised business outright.
2. Bank Finance Loans (Borrowed Capital)
When you want to borrow money from a bank, it is not good enough to simply ask for an amount and hope for the best. Banks offer various forms of finance. It is vital that you understand that and match your loan request to your actual funding needs. Within the small business (SME) environment, the following are the most popular loan formats:
5 Types of Bank Finance Loans
An overdraft is intended to take care of short-term dips in your business’s cash flow. This need may arise around month-end, for example, when payments fall due but your customers have not paid you yet. Overdraft finance is usually more expensive than loan capital. However, interest is charged on a daily basis, in line with the account balance. Any cash deposit you make reduces the balance and with it the interest charges. The banker will expect the balance to fluctuate throughout the month.The problem with an overdraft is that it can be called up at short notice, leaving your business exposed. For this reason, overdraft finance should only be used to supplement working capital requirements (short term finance), never to fund fixed assets (long term finance).
- Term Loan
To fund long-term capital needs, banks offer term loans. These are usually granted for a period of between 36 and 60 months. For as long as you adhere to the conditions of the loan, and especially as long as you make repayments at agreed intervals, the bank cannot call up the loan. On the downside, you have to keep the loan for the full period, even if you have surplus cash at your disposal. (Should you wish to terminate a term loan, a penalty payment will apply.)Subject to the arrangement you have made with the bank, term loans can be used to finance the acquisition of furnishings and fittings, equipment and even to bolster working capital.
- Asset Finance
The purchase of capital equipment and cars can be financed through some form of asset finance. Finance can be structured to the precise needs of your business and the expected useful life of the item to be financed influences the repayment period. Another advantage is that the item to be purchased can serve as surety for the loan, at least in part. In most instances, however, a deposit will be payable.Forms of asset finance are:
- Rental agreement – You enjoy the use of the item for a fixed period but never gain ownership. This form of finance is suitable for businesses where equipment has to be replaced on a regular basis, for example companies that operate in a hi-tech environment.
- Financial lease agreement – This type of arrangement offers tax advantages because lease payments are fully deductible. At the end of the pre-arranged lease period, you may be granted the option to purchase the item outright, usually at its written-down value.
- Instalment sale – The bank purchases an item of equipment and on-sells it to you. You pay monthly instalments, which will include interest. Initially, the bank owns the item outright, however, at the end of the agreed period ownership passes on to you.
If you have a stable customer base in the business-to-business arena, do repeat business with them and individual transactions are of relatively high value, you could “sell” your debtors book to a factoring house. You receive an agreed percentage of the total amount upon ceding the invoice, with the balance (minus finance charges) paid to you once your customer has paid the finance house. This form of finance is fairly expensive but it allows businesses to expand rapidly and has its place in the mix. You should know, however, that the credit risk remains with you – should your customer fail to pay, the finance house will expect you to reimburse them.
- Venture Capital
Venture capitalists are always on the lookout for opportunities to inject money and expertise into businesses with high growth potential but, and this is important, their decision to become involved is linked to a clear exit strategy. They gladly forego interest payments and profit payouts during the early years.Their objective is to build the business into a substantial entity and realise a substantial capital profit five to seven years down the line. This explains why venture capital funding does not play a major role in the SME sector, especially not during the start-up stage.
3. Funding Through Trading Activities
2 types of Funding through Trading Activities
- Raising Finance from Suppliers
By arranging payment terms with your suppliers, you effectively receive free finance. If you use supplier credit, you need to be careful to match it with the payment terms your customers demand; you also need to watch stock-turn or cash flow problems could arise.
- Raising Finance from Customers
- Depending on norms prevailing within your industry sector, you may be able to ask customers to put down deposits for goods they order, especially if custom processing is involved. Should this prove possible, it gives you access to free working capital.
- To encourage your customers to pay promptly, you could offer them settlement discounts. Keep in mind, though, that in most instances, this will work out far more expensive than a term loan or even an overdraft granted by your bank.
Working with Your Bank
Bankers often complain about the number of people who approach them for a loan but clearly have not done their homework. They have neither a business plan nor are they able to answer the most basic questions about the business in a convincing manner. Do not fall into this trap – a little preparation goes a long way. At the very minimum, the banker will expect you to provide realistic answers to the following questions.
- How much money do you need and how much will you contribute from your own resources?
The loan amount you ask for should be “just right”. If you borrow too much, you waste money on interest payments; if you borrow too little, you will soon face a cash crunch, and this could derail your plans.
- What precisely do you intend to spend the money on?
This is an important consideration for the banker, as it affects the value of the items bought (which can serve as collateral). If the equipment prescribed by your franchisor is highly specialised and does not have an established market, the value that can be realised in a forced sale may well be close to zero.
- How do you plan to structure repayments to the bank and what alternatives can you offer should the business’s cash flow fail to keep up with ongoing financial obligations?
What the banker would ideally like to hear is that you have put aside a nest egg which you can liquidate should the need arise, or have arranged a soft loan facility “just in case”.
- What can you offer as collateral?
Modern bankers will tell you that collateral (surety) is no longer the deal breaker it once was. This notwithstanding, the availability of collateral remains an important consideration. It is a good idea to prepare a list of items you own and are willing to offer as collateral, their realistic market value and how much equity (market value less outstanding finance) you hold in each.
The Loan Application
Following an initial discussion with your banker, you will be asked to complete a loan application. Although every bank has its own format, the basic information required will largely be the same.
As part of the loan application, you will be asked to submit your business plan and a cash flow projection – see below.
1. Business Plan
A business plan is an indispensable requirement for going into business. Some people like to compare its importance to the need for a detailed recipe for making that glorious chocolate cake. The chef cannot wait to get her hands into the dough, but without a detailed recipe and all the ingredients, weighed and measured in the correct proportions, she will not get very far. Being less poetic, we will simply say this: If you go on a trip without deciding in advance where you want to go and plan your route carefully, how will you know when you have arrived? Worse still, how will you know if you get lost along the way? Still not convinced?
Ten good reasons why you should have a business plan:
- Drafting a business plan forces you to think matters through in more detail than you otherwise would. This gives you a chance to identify potential problems at an early stage and find a way around them.
- The mere fact that you have taken the trouble to prepare a good business plan reflects careful analysis of the business’ potential. This reassures bankers and other providers of funds.
- Similarly, the business plan motivates other stakeholders to support the business. These include suppliers, customers, staff and the media.
- A business plan that is kept up to date, frequently referred to and used to monitor the direction the business takes helps you keep the business on track
- Frequent re-evaluation of the business plan requires the application of logical thought processes. This improves the quality of your decision-making.
- Regular review of the goals expressed in the business plan promotes lateral thinking among members of your team and facilitates the effectiveness of brainstorming sessions.
- The business plan becomes a measurement and evaluation tool in the widest sense of the word. It can be used to determine which departments have met or exceeded their goals, thus creating a benchmark for performance appraisals.
- In addition to individual goal-setting exercises, the business plan also facilitates staff buy-in through joint goal setting and progress tracking; this can be linked to the celebration of milestone events. (No need to be concerned about possible leaks. In practice, an increasing number of the world’s leading companies grant all their staff unfettered access to their business plan – with outstanding results.)
- In reviewing the business’ long-term potential, the business plan serves as an early warning system for the identification of potential problems and opportunities that may evolve in future. This facilitates the timely implementation of appropriate responses.
- Although the business plan contains confidential information, it can nevertheless serve as a source document for the creation of press releases and other general communications aimed at the business’ constituents in the broadest sense.
To help you compile a killer business plan, we have published detailed guidelines under the heading Drafting a Business Plan. And remember: the best time to get started is now!
2. Cash Flow Projection
The ability of your franchise to generate adequate cash flow is an important indicator of its viability. The cash flow projection is one document prospective funders will study carefully. They know from experience that unless the cash flow generated by your franchise can comfortably sustain ongoing operations, you may run out of cash and be forced to close your business’ doors before you even had a sporting chance to reap the rewards of your hard work.
What precisely does the term cash flow mean? It is the amount of cash inflows less the amount of cash outflows during a specific period. Please note that the emphasis is on cash, not sales or any other form of paper assets or liabilities but cold hard cash. In other words, no matter how impressive your sales figure may be, until your customers actually pay you for the goods they have purchased, the transaction has no impact on cash flow. (An exception is if you discount your invoices through a factoring company but this method of raising finance is not accessible to every company.)
The upside is that this works in reverse as well. In other words, no matter how much you purchase from your suppliers, cash flow remains unaffected until you actually pay them. Sounds reasonable enough, until you realise with horror that in practice, it isn’t always as simple as that…
For the following reasons:
- Most of your customers will expect you to grant them credit terms, especially if you are active in the business-to-business sector.
- By contrast, unless you manage to convince your key suppliers of your creditworthiness, many of them will expect you to pay them cash on delivery (COD) or at the end of the month during which purchases were made.
- To exacerbate the situation further, you will have to pay almost all expenses including salaries, wages, utilities and other operating costs in cash, some of it, like store rentals, even in advance.
- Keep in mind, too, that even if you have arranged credit terms with your suppliers, a situation could arise where goods remain in your store for longer than anticipated. As a result, you could be forced to pay your suppliers’ accounts for goods you have put in stock long before you have made the corresponding sale. At that point, you still have to give your customers terms.
To project the cash flow of your business, calculate the amounts of money you expect to receive during a specific period and deduct the amounts you expect to pay out. Remember that while a strong cash flow is important, it is not an indication of profitability. Growing sales can generate positive cash flow for a while even if the business operates at a loss but this is not sustainable.
Jessica has a background in Financial Management. In her current position as a Credit Analyst, she has the job of finding the best possible funding options for a business, based on its individual requirements. This has given her a unique insight into the alternative business lending industry, and a good view of what lenders expect from businesses seeking funding.