Franchising

Franchising

Franchising

Franchises are very popular in Australia, particularly for owners whom are venturing into business for the first time. This is because the business is basically setup for you and you don’t have to spend the time and money it takes to setup a new business from scratch. You are basically buying someone else’s business or brand together with all their systems, processes and marketing collateral as well as receiving guidance and support. Franchising has been described as buying a ‘business in a box’ and the general perception is that franchising is a very successful form of small business in Australia, however, some statistics suggest that:

  • Only 81% of franchisees are profitable
  • 58% of franchisees generate a profit of less than $50,000 per annum
  • 3% of franchisees generate a loss of more than $50,000

It is crucial that you consult with an accountant who has franchise experience before taking the leap and buying into a franchise. Here at McHenry Partners we have assisted a number of clients franchise their business and many more buy a franchise operation from Jim’s Mowing through to a McDonalds Restaurant. During the process, it is important that you also engage the services of a solicitor who understands Australian franchise laws because of the regulations and complex franchise agreements.

People are often surprised by the fact that finance can be difficult to obtain for a franchise as the banks will generally have more stringent lending criteria and reduced risk tolerance. Although your product development, production processes, branding and marketing collateral will be set in place by the franchisor, the banks will require you to provide them with some key information. You need to identify your establishment costs and the banks will demand budgets and cash flow projections and possibly a business plan before they will consider your finance application. The price range for franchises is broad, you may pay as little as $35,000 for a mowing territory to as much as $1 million or more for a McDonald’s restaurant. However, not all franchises have the same inclusions in their fees. For this reason, it is important to establish what is included and what is not. Normally it covers licensing costs (use of franchise name), rights to use systems, training costs, support, software requirements and site selection.

Below are examples of some possible additional costs that may be forgotten about when buying a franchise:

  • Shop fit-out (furniture, signage, etc.)
  • Inventory
  • Office supplies
  • Legal and accounting advice
  • Recruitment costs
  • Insurances
  • WorkCover
  • Finance repayments
  • Ongoing support fees
  • Franchise renewal fee

The advantages of the franchise model include:

  • Capitalising on existing brand awareness
  • Management experience with proven success
  • Marketing, administration and strategic support from ‘head office’
  • Being part of a large group provides buying power for supplies and marketing
  • Pre-established business systems with ongoing support
  • Designated geographic territory
  • Bank finance is often easier to obtain for a franchise rather than starting a business from scratch (note that some banks prefer certain franchises)

Some of the disadvantages of a franchise to consider would be:

  • Royalty fees payable to the franchisor eat into your profits
  • Reduced freedom in decision making
  • Franchisors often control the pricing of key supplies
  • Upfront franchise fees and significant start-up costs
  • Franchise fees calculated on sales turnover, not profitability
  • Most franchisors charge a significant start-up cost with the median retail start-up fee around $275,000

What exactly constitutes a franchise?

A franchise is an agreement or license between two parties where the franchisee (which can be a person or group) is given the rights to market a product or service using the trademark of the franchisor. The franchisee is obliged to pay the franchisor certain fees and royalties for the rights to market the product (or service) in Australia. In return, the franchisor has the obligation to provide these rights and generally support the franchisee. Therefore, the franchisor and franchisee have a strong vested interest in the success of the brand.

Typically there are two types of franchises, namely ‘business format franchising’ and ‘product and trade name franchising’. Business format franchising is very common in Australia and applies to industries like child care, fast food restaurants, automotive services, real estate, cafes, education, convenience stores, hairdressers etc. This format provides the franchisee with the use of trademarks and logos plus provides a turn key system for operating the business. The franchisors assist the franchisee with site selection, interior layout and design, hiring and training, advertising and marketing, product supply and more. In return, the franchisee pays an upfront fee and agrees to pay continuing royalties that help the franchisor provide research, development and support for the entire franchise system.

How much does a Franchise cost?

As mentioned earlier, the price paid for a franchise will vary dramatically based on what is included in the price and also the particular franchise you are buying.

When buying a franchise it is important to do your due diligence and research. It is our recommendation that you should spend around one hour on research for each $1,000 that you plan to invest in a franchise. For example, if you were planning on spending $100,000 on a franchise, you should put in 100 hours of research and education prior to the purchase. Proper due diligence could take months and is an important step that you should take. Meeting with current or past franchisees and getting their feedback is strongly recommended as they will be able to provide you with important information that you may not be able to find elsewhere. Obviously, if the feedback you are receiving is constantly negative you may need to reconsider your decision to invest in that franchise.

When valuing a business or franchise there are some basic valuation guidelines. Business values are generally based on an EBIT (Earnings before Interest and Tax) of 25% after providing the business owner with a fair salary.  For example, let’s assume your business earnings (before interest and tax) is $100,000 before paying you a salary. If a fair salary for the business operator is $60,000 per annum then the business has an EBIT (after your salary) of $40,000. If you are looking for a 25% return on your investment then a fair price for the business is $160,000 (because a 25% return on a $160,000 outlay is $40,000 per annum).

This is obviously just a guideline because we see businesses bought and sold with much lower EBIT’s (particularly for lower cost businesses) and sold with EBIT’s above 30%. Factors that will influence the potential return and the price of the franchise include:

  • How long the franchise has existed and how many franchisees are operating
  • Whether you are buying an existing franchise or opening a new site
  • The risk associated with the industry (food, child care, hairdressing etc.)
  • The total price of the franchise business
  • The initial term of the contract and renewal options

It is critical during the valuation process that you calculate the business’ EBIT based on profit and loss projections you prepare. Although the franchisor will provide you with some forecasts and projections that they have prepared these should only be used as a guide. This is also the case when buying an existing business, although this will be based on historical financial statements and other figures prepared by the vendor.

There are a number of expenses that the franchisor may not have included that will be specific to the franchisee such as, interest on borrowings, depreciation, motor vehicle expenses, the owner’s wage and income tax. The figures provided will not tell you how the business will perform in the future or factor in the opening of a major competitor just around the corner last month. Generally speaking, your projections and forecasts (not those provided to you) should form the basis of your decision to buy a business or franchise.

There is a Code of Conduct in place that franchisors must abide by which includes key areas of disclosure, dispute resolution and franchisee rights. Franchisors have been known to provide projections of your earnings, however, these are sometimes misleading. Below are some basic questions that should be asked when reviewing earning projections:

  • Are the figures based on gross sales only or do they include GST or are they net of actual costs as well?
  • Is it based on average incomes?
  • Are all franchisees included in the projection? (under performing franchisees may have been omitted)
  • If you removed the top 10% of the franchisees would the figures change dramatically? In other words, are there a small number of high performers inflating the figures?
  • Are there any Company owned franchises? These may have different or discounted costs.

What is the break even point and when I can expect a return on my investment? Often franchise agreements run for 5 years without a guarantee of an extension. You need to calculate what your return on investment would be at the end of the term in case you have to walk away.

Get Advice!

We demand that franchise agreements be perused by a professional, preferably a solicitor and an accountant who has franchise industry expertise. We demand this because many franchisees don’t fully understand exactly what they are buying into and don’t realise the extent of the ongoing costs that they may be required to pay. By having an experienced professional go over your agreement they are able to clearly explain to you the costs, both upfront and ongoing, that you will be required to pay. Going through this step can avoid any misunderstanding and ensure that the existence of any hidden costs doesn’t drive a wedge between the franchisee and franchisor from the outset.

Although it may not be your first thought when entering into a franchise agreement, franchisees need to understand that the franchise agreement will terminate at some point in time. We always recommend that you start your business with the end in mind. Although the contract may provide options to renew, this is not always the case. For this reason, your tax structure needs to factor in the potential discount capital gains tax concessions and the possible admission of new partners. You also need to understand your rights regarding on-selling your franchise or business to a third party and be clear about your choices at the end of each option. By not doing the required research and receiving the necessary legal advice you can be left in a vulnerable position when a franchise agreement ends. Buyer beware is the message and we still hear horror stories from franchisees who say, “We were simply unaware that this could happen” when it was clearly spelt out in the contract. You also need to be clear about your rights as a franchisee to sales generated online so the right legal advice is just so important.

Legislative Requirements

There are specific legislative requirements in place for franchises and if you are considering purchasing a franchise you should familiarise yourself with these. It is a part of these requirements that a franchisor must give a potential franchisee a disclosure document at least 14 days before the new franchisee enters into the franchise agreement. The contents of the disclosure document are set out in the legislation but in terms of the financial aspects it will cover the following:

  • Provide an estimate of the total costs to establish a franchise (Section 13)
  • Provide details of ongoing payments to the franchisor (Section 13)
  • Provide some information about financial performance (Section 19), however, franchisors can elect not to disclose any information
  • Provide a summary of the most recent financial statements of the franchisor (Section 20) or alternatively, the franchisor can provide a statement verified by a registered company auditor that the franchisor is able to meet its debts as and when they fall due.

The Traps

Running a business requires energy, passion, persistence and commitment. While some franchisors market their franchise as a simple ‘turn key’ operation, it is not that simple. Hard work is the key to success and if the business was churning out profits then why wouldn’t the owner just set up more sites and employ more staff.

The first thing that prospective franchisees will look at and want to know is how much money they will earn. It’s a fundamental part of the buying equation and some franchisors now offer income guarantees, particularly in the service franchises. This can be very reassuring and appealing to first-time business owners moving from a salary employment position with a regular income. These income guarantees are often stated as ‘$1000 a week for the first ten weeks’ to reassure the franchisee and reduce the perceived risk of investing.

Other franchisors are offering prospective franchisees a guaranteed income of say $50,000 per annum. This provides the franchisee with a degree of income stability for the first year of trading and can help the franchisee secure finance. Although, franchisees need to bear in mind that income guarantees do expire so it is important that buyers look beyond income guarantees when assessing a franchise. There are several aspects in the total package received when buying a franchise that need to be assessed such as:

  • Price
  • Training
  • Equipment
  • Marketing materials
  • Ongoing fees
  • Income guarantees

It is crucial that you don’t make your decision based solely on one of these aspects because in some instances the income guarantee is really just a recruitment incentive.

Prospective franchisees should be able to obtain enough information from the franchisor about the franchise system prior to purchase. Some areas to examine to help you make an informed decision may include:

  • How long has the franchisor been in business?\
  • What are the long-term goals and strategies for growth?
  • What qualifications and experience do the Directors and managers hold?
  • What ongoing support and training is provided and in what format?
  • What recent innovations have been introduced into the franchise?
  • What has been the experience of current and former franchisees?
  • Is the business soundly financed? You should have an opportunity to review audited financial records (preferably with assistance from your accountant)
  • Eventually you will want to sell or exit your franchise. Therefore it is important to understand how the agreement ends.

In summary, there are numerous issues to consider when buying into a franchise. There is no substitute for professional advice and over the years we have helped many franchisees who have ran child care centres, fast food restaurants, automotive services, real estate agencies, cafes, education facilities, convenience stores, hairdressers and several franchisors work through the process.

Contact us today about your franchise idea or purchase and we’ll show you why we are recognised as accounting experts in the field of franchising.

To take the next step we invite you to book a FREE, no obligation, one hour introductory consultation to discuss your business needs. You’ll get practical business, tax, marketing and financial advice that could have a significant impact on your bottom line. To book a time, call us today on 1300 789 844 or complete your details in the box at the top of this page.