The level of contribution by the franchisee is a sound indication of the owner’s commitment. We generally recommend that you engage the franchisor in understanding their acceptable level of own contribution requirements for their brand. This will help you assess how much of your personal savings go toward the franchise.
Current industry norms require potential franchisees to have between 40%-60% unencumbered cash. Unencumbered funds help with cash flow projections and reduce gearing levels for the business. It also provides comfort to the financier and the franchisor in respect of creating a reasonable margin of safety, which is essential to have in case a business experiences financial pressures.
Use loans to cover the shortfall
The majority of the franchise finance for the operation should come from your own savings. However, if a shortfall exists, you have the option to fund these via loans or investor funding.
Remember that borrowings attract interest which will bring additional cost to the business. This can impact on both profitability and free operating cash flow. If the borrowing is short term, the repayment required will be at a higher level than borrowing structured over a longer term. In both cases, repaying the loan can adversely impact on the cash flow of the business.
Business owners must also be aware that failure to honour borrowing commitments can result in a poor credit rating, additional costs and withdrawal of support from other creditors. An advantage of debt however is that some form of tax relief can be obtained from the interest paid on the loan, as this reduces taxable income.
Investor funding advantages
Investor funding has the main advantage of funding that doesn’t have to be repaid. Any dividends payable to a shareholder will wait until the business is solvent, profitable and the cash flow of the business allows the payment of dividends. It is therefore a highly desirable option to consider in the early years when the business is still in the growth phase.
The disadvantage of this however is that a portion of the control of the business will have to be given up by way of shareholding. The investor will also have the right to share in all future profits that the business will generate. In the long run this may prove to be expensive funding as the business grows strongly with good cash flows.
One of highest risks of a business in the initial stage is not having adequate cash, in the absence of accumulated resources, to honour monthly expenses like salaries, electricity, rent, and so on. Some provision should therefore be made upfront to have adequate working capital for the first few months.
Discuss the cash flow needs of the business and the expected results with the franchisor, as cash flows for businesses in different industries differ vastly. Things to be considered are the level and turnaround times of stock, debtor payments and creditors’ terms, and unforeseen expenses.
A good average would be to ensure at least three months of operating expenses is kept in reserves. Alternatively, an overdraft for a similar amount can be applied for from a bank.