Types of franchise finance that you will need to be successful
Buying into a franchise requires a substantial investment. The good news is that funding mechanisms do exist; you just have to know what they are so that you can use them to your advantage.
It’s important to note that you’ll have to fund your franchise through a mix of equity (own capital) and loans (borrowed capital) but what does this mean?. You cannot expect a one hundred percent loan and there is no getting away from investing your hard-earned savings into the business.
To ensure that you have every chance at success here is a breakdown of the 5 major forms of franchise finance to assist you in your business venture.
1. Own cash resources
The reality is, you can’t expect outside funders to give you money unless you’re willing and able to contribute some cash of your own. This means, you have to have a cash sum to invest towards the establishment of the business.
Pros and cons of own cash resources
Contributing from your own resources will help you make sure the person or institutions you want to borrow from give you a loan. If, for example, a banker sees that you have some money of your own to start off with, he’ll be convinced you’re capable of handling your financial affairs well and chances are, he’ll give you a loan. In addition; there will be no questions about your commitment to the business if you have a big stake in it.
The downside is, if you don’t have money to contribute, it may take you a bit longer to realise your dream of owning a franchise. You may have to put your dream on hold so you can save some money during this time.
You could also consider lower cost franchises , remembering that low entry cost does not necessarily mean low returns or less of an effort to make the business successful.
2. Soft loans
To make owning a franchise a reality could mean borrowing money from your family and friends.
Pros and cons of soft loans
The terms of soft loans tend to be lenient, for example, they carry little interest or no interest and sometimes there’s no fixed repayment date.
One of the disadvantages of a soft loan is, the lender may, for example, decide to ask for his money back when the business’s cash flow is tight. If you want to take this route, it’s advisable you ask a lawyer to draw up a written agreement that sets out the terms of the loan, the consequences as well as the rights and obligations of each party. Transparency is critical here.
While your friends and family members may be willing to help you make your dreams come true, they need to know what they’re getting themselves into so there’s no misunderstanding later on.
3. Taking partners on board
You don’t have to go at it alone. You could invite others to join you in the venture in exchange for a share in the business.
Pros and cons of taking partners on board
Taking in partners has the added advantage that you can share the burden of building the business.
The downside here is, some people could reveal their true colours or be difficult to work with later on and you may have some difficulty running the business. That’s why it’s important to carefully select your partners if you go this route. The last thing you want is to have business partners who make it hard for you to run the company.
Choose people who share your vision for the business and make sure they also bring complementary business skills into the business.
4. Joint venture arrangements
Some franchisors are willing to enter into joint venture arrangements.
Pros and cons of joint venture arrangements
Entering into this arrangement means the franchisor takes a large share in the franchise. This in turn reduces the amount of cash you need to invest. This type of arrangement makes it easier for you, the franchisee, to get a loan because the banker knows that the franchisor has an extra incentive to ensure the business’s success.
Another advantage is, if you can convince the franchisor of your choice that you are the perfect person for a joint venture, you can negotiate a deal that allows you to make your initial contribution in the form of “sweat equity”. This means, 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. The profits the franchise generate are then allocated towards this until finally you own the franchised business completely.
The downside is, if your plan was to own a franchise outright, you may have to wait a few years to make this a reality.
Financing a franchise is easier than financing an independent business. The major banks in South Africa support the business model of franchising and they offer different types of finance.
As someone who wants to own a franchise, it’s important that you understand what banks offer and match your loan request to your funding needs.
Take a look at the popular loan formats that banks offer:
1. Term loan
Banks offer term loans to fund the long-term capital needs for the franchise operation. The bank will usually grant a term loan for a period of between 36 and 60 months. You can, for example, use a term loan to pay the initial franchise fee and purchase furniture, equipment etc..
Pros and cons of a term loan
What’s good about a term loan is, if you stick to the terms and conditions of the loan (you make repayments at agreed intervals), it is a win / win for your business and the bank.
On the downside, you have to keep the loan for the full period, even if you have surplus cash at your disposal. If you want to settle a term loan prior to its period, a penalty payment will apply. You will also need to have tangible collateral available to secure this type of lending such as a property that is not fully financed or investments that may be ceded to the bank.
An overdraft is meant to take care of short-term dips in your business’s cash flow. You could, for example, need an overdraft around month-end when payments fall due, but your customers haven’t paid you yet or to buy extra stock in preparation for a busy period eg: food businesses in the December holidays.
Pros and cons of an overdraft
Overdraft finance is usually more expensive than loan capital. What’s positive is, the banker charges interest 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. You will need to be very disciplined and fully understand how an overdraft works to use it to your best advantage.
The problem with an overdraft is that it can be called up at short notice, leaving your business exposed. It’s for this reason that you should only use overdraft finance to help you with working capital requirements (short-term finance) and never to fund fixed assets (long-term finance).
3. Asset finance
For your business needs like equipment and company cars, banks offer asset finance. The structure of asset finance (for example, repayment periods) will depend on your business needs and what you and the bank agree on.
The types of asset finance that are available are:
- Rental agreement: With a rental agreement, you get to use the item for a fixed period but never gain ownership. This form of finance is suitable for businesses that have to replace equipment on a regular basis (for example, companies that operate in a hi-tech environment).
- Financial lease agreement: With this type of arrangement, you get tax benefits because lease payments are fully deductible. At the end of the pre-arranged lease period, you could get an option to buy the item outright, usually at its written-down value.
- Instalment sale: Here, the bank buys an item of equipment and sells it to you. You then pay monthly instalments, which will include interest. Initially, the bank owns the item outright, but at the end of the agreed period you get to own the item.
Pros and cons of asset finance
The benefit of asset finance is the item you want to buy for the business can serve as surety for the loan, at least in part. The downside is, in most cases, you must pay a deposit.
If you have a stable customer base in the business-to-business arena, conduct business with them frequently and individual transactions are of relatively high value, you could “sell” your debtors book to a factoring house.
Pros and cons of factoring
Factoring means you get 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 very expensive, but it allows businesses to expand rapidly.
It’s important to note that if you take this route, the credit risk remains with you. This means if your customer fails to pay, the finance house will expect you to reimburse them.
Funding through trading activities
1. Raising finance from suppliers
You can arrange favourable payment terms with your suppliers in a way that allows you to get ‘free finance’. Favourable payment terms are not easy to come by – they demand some very strong negotiation skills and usually a trusted historical relationship with the supplier. In turn many suppliers, especially other small businesses, simply can’t afford this drag on their cash flow.
Pros and cons of funding through trading activities
Raising finance from suppliers means you get some breathing space in order to generate income.
If you use supplier credit, you need to be careful to match it with the payment terms your customers demand. Plus you also need to watch stock-turn. If you don’t, you’ll quickly run into cash flow problems.
2. Raising finance from customers
Depending on the sector you’re in, you can ask customers to put down deposits for goods they order, especially if custom processing is involved.
Pros and cons of funding through attractive payment terms
If you succeed in raising finance from customers, you’ll have access to free working capital.
You can also encourage your customers to pay on time by giving them payment discounts. Just bear in mind that in many instances, this tends to be more expensive than, say, a term loan or even an overdraft from a bank.
Getting funding from institutions
1. Franchise Finance
The National Empowerment Fund offers Franchise Finance. On its website, the National Empowerment Fund explains that the Franchise Finance product is “meant to help black entrepreneurs who wish to start their own businesses by buying a franchise linked to a particular brand to reduce risks associated with start-up businesses lacking a track record.”
You can find the terms and conditions about Franchise Finance on the National Empowerment Fund website.
2. Franchise Fund
In March 2014, Business Partners Limited launched its Franchise Fund. The fund has the support of the Development Bank of Southern Africa. Its aim is to “allow young and previously disadvantaged entrepreneurs, with limited assets and access to capital, to qualify as franchisees.” (Source: www.businesspartners.co.za).
To get more information on the Franchise Fund and its terms and conditions, check out Business Partners Limited’s website.