Westpac - Build On Solid Ground

Buying a franchise with a strong brand and a proven business model definitely improves your chances of business success, but even franchises are not exempt from normal economic factors. Anyone looking at buying a business should be aware of some of the common problems that can arise with any business, franchised or not. Here, we'll look at a few of the reasons franchises can fail, with emphasis on financial management.

The Wrong Funding Structure

When funding any business, the question should always be ‘What can the business afford?' rather than ‘How much can I draw down on my home loan?' or ‘How much would the bank lend against the business?'

The typical business loan runs over a relatively short term of 3-5 years. This means pretty aggressive capital repayments compared to a loan secured against property, where repayments are over 25 years or more and interest rates tend to be lower. For example, on a loan of $100,000, repayments of capital and interest could vary from as little as $908 per month up to $3230 depending on the term and security involved. How you structure your funding can therefore make a massive difference to cash flow and affordability.

If the business cash flow can't support the debt repayments, the result will be increasing debt and ultimately failure. You'd be surprised how many people get into this position, so don't let it happen to you - take advice from a franchise specialist bank when setting up the business.

Under-Capitalisation

Make sure that costings provided by the franchisor and shopfitters for new outlets are realistic. We have sometimes seen cost overruns of 30-50% which can mean that the business is not financially viable from day one. Franchisors should have a good handle on what costs should be - make sure they are aware of any variances immediately.

Most franchise businesses turn cashflow positive quite quickly and do not require large overdrafts. However there may be some initial, one-off, expenses or seasonality which can cause problems if not foreseen. For example, failure to take into account pre-Christmas ordering may create some serious issues for retail franchises. Listen to the guidance of the franchisor and the experience of other franchisees and plan accordingly.

Bad Management & Poor Information

Franchises are normally praised for their proven business systems, but not all provide or enforce adequate management information processes. We have had experience of franchisees who never did monthly management accounts and only prepared annual accounts at the end of the financial year. This meant that they had no way to make informed decisions or steer the business other than using historical information. Although they normally had a good idea of the turnover, they had no idea what their GP margin, wage cost percentage or, indeed, profit was. In some cases, they were suffering serious shrinkage with product stolen by staff and customers but had no way to know it - until it was too late.

We have seen numerous cases of businesses failing because of bad leadership and decisions based on inadequate information. Some franchise systems insist that franchisees adopt healthy reporting practices that actually help them run the business, while others could provide more help. A good point of sale and/or stock management system will greatly assist franchisees. Make sure your franchise has the right information systems in place - and use them.

Rapid Growth

It has been said that more businesses have failed because of growing too rapidly than any other reason. In franchises where stock is very capital-intensive, rapid growth means more money is needed at a time when the business is not yet proven and finds it difficult to raise funds. Many owners say that they just can't understand it: ‘sales were great just before we got into trouble.'

The solution is again proper management information, especially cash flow budgets that predict the need for additional funding and explain to the bank how the additional funds will be repaid.

Failure To Take Responsibility

Some people buy franchise businesses with the idea that a successful model and strong systems mean that they do not need to take personal responsibility for the success of the business and that the franchisor is there as a sort of big brother who will solve all problems. This is incorrect: franchisors are normally very supportive on operational matters, but they will not be able to help with issues like the wrong funding structure or sustained losses because of bad management. Your business is your business.

Unethical Franchisors

Sadly, there are a few franchisors out there that oversell their opportunity without any real proof that the business model is profitable. If the franchisor is over-optimistic about a site's potential, the franchisee is the one left struggling. As franchisors typically derive their revenue from turnover, they get their income whether the franchisee is struggling or not. This is clearly not tenable in the long term and good franchisors realise that the long term profitability of the individual franchisees is very much in their interest as well. To avoid choosing the wrong franchisor, talk to other franchisees, your franchise banker and industry experts.

Other reasons

All sorts of external factors can impact upon a business's long-term prospect. Normal economic cycles, new competition or long-term changes in demand can all create problems. For the individual franchise business, so can paying too much rent, poor cost control, bad or non-existent local marketing or lack of owner's involvement.

The good news is that the better franchise systems are aware of all these things and actively plan to counteract negative trends. They invest in renewing the concept to protect and grow margins, and that's why good franchises prosper when other small businesses struggle. By selecting your franchise carefully and taking good advice before you purchase, you can do the same. Minimise your risk - and maximise your profit.

This article is taken from Franchise New Zealand magazine Volume 16 Issue 2

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