Do Business Well

On the positive side, a well structured franchise concept will elevate the business to the status of a national or even international player much sooner than he could realistically have hoped for, had expansion been attempted through traditional channels. Experience has shown, too, that although it takes time and patience, the synergies created through franchising have the potential to make the business extremely profitable over time. Just think of McDonald’s.

Along similar lines, the second hurdle every prospective franchisor will have to negotiate is the need for utmost realism when initial and ongoing fees are calculated. Given the long-term nature of a typical franchise agreement, this decision can make or break the new franchise operation. Set fees too high and few people will join the network. Those who do are likely to struggle to make ends meet, thus virtually ensuring that the long-term prospects of the network remain poor. And if the franchisor acts as the main supplier to his franchisees as well, he must take care to ensure that prices for goods are set in such a way that the franchisee’s competitiveness remains intact.

Franchisees must be secure in the knowledge that their franchisor offers them the best possible deals at all times. Although profit generation at unit level remains the franchisee’s responsibility, the entire franchise package must be structured in such a way that it offers those who follow the franchisor’s instructions to the letter a realistic chance to achieve above- average returns. Franchisors who overlook these important points are almost certain to fail, and deservedly so.

Typical financial transactions

The financial transactions that occur in a franchise arrangement can conveniently be grouped as follows:

Franchisor’s investment

At the outset, unless the franchise is the offshoot of an existing business that has been operated successfully for years, the prospective franchisor will have to make an investment into the development and testing of the concept. And even if the basic business concept is in place, the step of franchising it will necessitate certain modifications. The next step will bethe creation of the franchise package, followed by the setting-up of the franchisee support infrastructure.

We have already touched on the fact that on an ongoing basis, the franchisor will have to fund operational costs arising from the provision of franchisee support in the widest sense of the word. This is as good a place as any to point out that, should the franchisor be under-funded, he may find it difficult to survive the initial two or three years following the launch of the franchise.

The reasons for this are not hard to find. Initially, the network will have very few members and as they are all newly established, they will require an inordinate amount of assistance. To exacerbate matters further, their sales levels will typically be low, thus limiting the income stream from management services fees the franchisor can expect to receive.

To cut down on franchisee support at this stage would be a fatal mistake, and should not even be considered as an option. This is why it is essential to ensure that a new franchise operation is established on the strengths of projections extending over 3 to 5 years, and is adequately funded to survive this difficult period.

Franchisee’s investment

A new franchisee’s investment can conveniently be broken down into the initial fee he will have to pay to the franchisor, the required investment in fixed assets needed for the operation of the business and the working capital he will need to fund ongoing operations.

Income streams arising from franchising

While the franchisee expects to earn an income from the operation of the franchised unit, the franchisor’s primary source of earnings will be the various fees his franchisees will be obliged to pay. As we shall see, however, franchisors could develop some additional sources of income as Nell without necessarily infringing upon the spirit of ethical franchising.

Types of franchise fees

Franchise fees can be divided into the initial fee, which is payable only once, namely at the beginning of the relationship, and a number of ongoing fees which are payable periodically throughout the franchise relationship.

The initial franchise fee

Sometimes also called an up-front fee, the initial franchise fee is a lump sum that the franchisee is required to pay to the franchisor. It usually falls due in tandem with the signing of the franchise agreement and is, in effect, a “joining fee“. In exchange for its payment, the franchisee is granted access to the franchisor’s intellectual property package as well as receiving initial training and practical support in the establishment of the franchised business. The precise nature and extent of initial assistance should be clearly set out in the franchise agreement.

The initial fee does ordinarily not pay for equipment, shopfittings, stock or any other items that may be needed to prepare the franchised business for trading.

In South Africa, it is customary to calculate the initial franchise fee based on the principle of cost recovery. Using the costs incurred in putting together the franchise package as the base figure, franchisors add the projected cost of franchisee recruitment, setting-up assistance and initial training, usually estimated over a three to five year period. Occasionally, a small goodwill component is also added. The grand total they arrive at in this way is equal to the total projected cost of establishing the network. To calculate the amount each franchisee will be charged as initial fee, franchisors estimate the number of franchised units they are likely to set up over the same period and apportion costs on a pro rata basis.

There seems to be widespread agreement that the size or potential of a specific territory should not be taken into account when initial fees are calculated. In other words, initial fees will generally be the same throughout the network, no matter where the territory under negotiation is located, or what its perceived potential may be.

However, some companies have a policy of increasing the goodwill component of the initial fee over time, in line with the increasing maturity of

the network. This is based on the reasonable assumption that the value of a new brand will be lower than that of a well-established brand that already commands a high level of recognition in the market place.

As can be seen, initial franchise fees should be determined based on the cost of creating the franchise package and influenced by the extent of initial assistance and training the franchisor offers new franchisees.

As a result, initial franchise fees vary quite significantly across industries, with the national average across all industries now standing at R53 000,00 (The Franchize Factor 1999/2000).

Renewal fee

Based on the statement we made earlier, namely that initial franchise fees are primarily intended to reimburse the franchisor for costs he incurred in creating the franchise opportunity, a justification for charging this fee for a second time, namely when the franchise agreement comes up for renewal, would be hard to find.

The franchisee is well established at that point and it is likely that he has in fact made a significant contribution to the current brand equity in his territory, so how can he be charged again? Some franchisors persist in charging such fees nonetheless and although this is not illegal per se, it smacks of exploitation. Franchisees should strenuously resist any attempts by their franchisors to collect a renewal fee at the end of the initial term of the franchise agreement.

Ongoing fees Management services fee

This is the ongoing fee that is commonly paid by franchisees to their franchisors. Ideally, it should be calculated as a percentage of the franchisee’s sales. Based on this simple formula, the more the franchisor invests in brand building and franchisee support, the quicker his franchisees‘ market share is likely to grow. Not only will this make franchisees extremely happy, it will also impact positively on the franchisor’s fee income, resulting in the famous win/win situation that lies at the heart of every successful franchise.

Management services fee percentages vary significantly depending on the industry within which the franchise operates. According to The Franchize Factor 1999/2000, the average level of management services fees that are currently charged is 8%. The highest recorded figure is 20%, applied in a service-type franchise, whilst retailers of fast-moving consumer goods often charge as little as 1%.

A wide discrepancy indeed, but what does it really mean? We must point out that, looked upon in isolation, these percentage figures are almost meaningless. It is conceivable that in some circumstances, 1% may be too high whilst in others, 20% is justified. This can be determined only by taking the value of services offered by the franchisor into account, as well as whether competitive pressures allow the franchisee sufficient mark-up to afford the higher fee without eroding his profitability.

Another reality to be taken into account is that in the instance of at least one network that charges 1% as management services fees, their franchisees‘ sales levels are extremely high. Although based on a mere 1% of sales, this still translates into a reasonable income stream for the franchisor. In fact, it enables him to provide the standard range of support services to his franchisees and still make a fair profit.

By contrast, average turnovers of some basic home maintenance services are typically low, especially if they are of the “one-man-and-a-van” type where the franchisee performs the service himself. Add to this the fact that this type of franchisee is likely to require a greater level of ongoing support, and the 20% fee income the franchisor receives may not be such a bargain after all.

More than mere semantics

On occasion, the management services fee is described as a royalty, but this is an oversimplification. In today’s language use, an entitlement to a royalty payment flows from established rights alone, as it happens for instance in the music industry. Once an artist has recorded a piece of music, he is entitled to ongoing royalties in the form of a percentage of CD sales. He will not be expected to physically produce the CD’s or deliver them to the music stores. Rather, he can sit back and enjoy the royalty stream for as long as sales occur.

A franchisor, by contrast, has been paid for the right to use his intellectual property package by means of the initial fee. He is entitled to receive a management services fee on an ongoing basis, but this must be in exchange for ongoing performance. Depending on the type of business, the franchisor can be expected to develop new products, build the brand, undertake market research, provide operational support, audit his franchisees‘ performance and do a myriad other things that have the capacity to advance the business for the benefit of all members of the network.

There is really only one way of determining an appropriate fee structure. The franchisor must calculate the cost of operating an effective franchisee support infrastructure, add a reasonable mark-up and see whether the resulting total can be recouped from the projected number of franchisees without putting them out of business. Having operated one or more outlets at the pilot stage, the franchisor will have a feel for the potential profitability of the business, and what franchisees will realistically be able to afford.

The setting of fees is a bit of a juggling act and we have already mentioned the problem this is likely to create in the early days of a franchised network’s existence. One or just a very few franchises will be operational, fee income will be low and the demand for support at an all-time high. It will be prudent to expect that the franchisee support division will be running at a loss for some time. Should calculations indicate that at realistic fee levels, the franchisor will never be able to recoup his costs and make a fair profit, even once a reasonable number of franchises have been sold, this would be an indication that the business is not franchiseable after all.

Fixed management services fees

Some franchisors continue to charge fixed management services fees. Under such an arrangement, franchisees are contractually bound to pay a fixed amount each month, regardless of the level of sales they achieve. On the surface of it, the reasons these franchisors offer in defense of their fee structure might sound extremely reasonable but their thinking is flawed. By charging a fixed fee, these franchisors contravene the spirit of franchising by removing the win/win – lose/lose aspect from the relationship. In the short term, they have little to lose, as the hapless franchisees will be obliged to pay up anyway, no matter how they might struggle to make ends meet. And should those franchisees manage to perform better than expected, their franchisor would still have little incentive to offer support, as he cannot hope to benefit from improved business activity.

Income from product supplies

Compulsory purchase arrangements, meaning that the franchisee is contractually bound to purchase goods from the franchisor, or from sources prescribed by the franchisor, are a controversial issue. On the one hand, the opportunity to supply a captive network of enthusiastic resellers is frequently the sole rationale for a network’s existence. On the other hand, the potential for misuse of the arrangement is obvious, and unscrupulous franchisors could use such an arrangement to limit their franchisees‘ ability to make a profit.

In the real world, however, many experienced franchisees consider joint purchasing arrangements to be among the main benefits of being a member of a franchised network. They have recognised that as long as the deal is structured fairly, it puts them on a par with the major chains. They observe, with some justification, that whether the franchisor acts as the supplier and marks up the goods or arranges network-wide deals on behalf of the entire network is of little concern to them, as long as they derive genuine group benefits.

According to The Franchize Factor 1999/2000, 63% of franchisors supply their franchisees with products for resale. Of these, only 32% claim to make a profit on these transactions. The survey does not reveal why less than one third of those who take the trouble to act as suppliers to their franchisees fail to profit from an activity certain to place considerable administrative and financial burdens on their businesses.

Every prospective franchisee should -

Know how franchise fees are calculated so that he can judge whether they are fair.

Be able to relate the level of fees to the range and quality of services he receives; if the value of services received is below the amount the franchisee is expected to pay, it may difficult to justify the franchisor’s ongoing involvement.

Examine the franchisor’s approach to franchise fees. This will offer interesting insights into the franchisor’s attitude to franchising. If the franchisor is also the supplier of a product, or range of products, the method of adjusting prices requires scrutiny.

Two factors clearly emerge: firstly, so far as the franchisor is concerned, he must budget to ensure that the flow of fees which he can expect to receive from the various sources are sufficient to produce the return he needs to cover his overheads and to make a reasonable profit. All this should happen within a realistic time frame, but keeping his growth prospects in mind. Secondly, so far as the franchisee is concerned, he must ascertain the sources of the franchisor’s income. He must satisfy himself that the franchisor will not be in a position unfairly to take advantage of him.

Martin Mendelsohn in The Guide To Franchising
5th edition, published by Cassell (UK)

)ne can only speculate that they receive periodic rebates from their uppliers that are based on network-wide purchases. We hasten to add that there is nothing wrong with such an arrangement, assuming of course ‘at the rebates are based on the high volumes purchased by the network s a whole, and not recouped from franchisees in the form of hidden price increases. After all, the franchisor facilitates the transaction to the benefit f the network, so why should he not be entitled to a reasonable return?

There is one proviso, though: In the interest of full disclosure, franchisees
could be made aware of any benefits the franchisor may receive, directly
indirectly, from compulsory supply arrangements. This is in factstipulated in the Code of Ethics and Business Practices of the Franchise Association of Southern Africa and indications are that the relevant clausE will be further strengthened in the not too distant future.

Escape clause

In the spirit of fairness, every compulsory purchase agreement should contain a clause to the effect that the franchisee is free to purchase from alternative sources, should the franchisor be unable to deliver. Some franchisors go one step further by inserting an escape clause linked to the price of goods. Such a clause would provide that, should the franchisee be able to purchase goods of identical quality at a lower price, usually quantified by stipulation of a minimum percentage value, from a legitimate source that is open to all other members of the network and regular supply is assured, he would be free to do so.

Other fees

Some franchisors offer administration and accounting services to their franchisees or arrange other business services in bulk. As long as franchisees derive genuine benefits from such arrangements, this is acceptable, but the same proviso as set out in the paragraph headed “Escape Clause” would apply.

Marketing fund

Most franchise networks require their franchisees to contribute to a central marketing fund. Monies in this fund are earmarked to pay for product advertising, often at a regional level initially when the network is still in its infancy, and at a national level once national coverage has been achieved. Quoting The Franchize Factor 1999/2000 once more, during the survey period 62% of respondents had operated formal advertising or marketing funds and, on average, had collected a contribution of 2% of franchisees‘ sales.

Unlike the management services fee, however, which must contain an element of profit in favour of the franchisor, contributions to the marketing fund should be applied exclusively to the funding of product-related promotional activities. Moreover, the franchisor’s own (company-owned) stores can be expected to contribute to the fund in equal measure, as they are bound to benefit from the promotional activities paid for by the fund as well. In this context, two further comments may be appropriate:

Whilst the implementation of fixed management services fees is not encouraged, the same concerns would not be raised when it comes to fixed contributions to the marketing fund. This would mean that the franchisor, instead of levying a percentage of sales, would charge a fixed monthly fee, especially if it has been set after consultation with a franchisee representative body. A fixed marketing services levy makes it possible to predict the fund’s income with certainty and enables the franchisor to enter into favourable advertising deals on behalf of the network.

Whilst the marketing fund covers the cost of regional or national advertising, franchisees will be expected to undertake local advertising for their own account. In fact, many franchise agreements contain a clause that stipulates the minimum amount franchisees are obliged to spend on this activity, and this figure should be shown in the initial financial projections.

Investment in fixed assets

Although the franchisor can be expected to provide detailed specifications and introduce the new franchisee to approved suppliers, it ordinarily is the franchisee’s responsibility to pay for the fitting-out and equipping of the franchise. In some instances, the franchisor will identify a site, decorate and equip it and sell the complete package to a franchisee. Under this scenario, which is often described as a turnkey solution, franchisors sometimes make the mistake of quoting an all-inclusive figure as a purchase price.

Only on closer investigation will it emerge that this “price” is in fact made up of two components, namely the initial franchise fee and the investment into the business. The problem with this approach is that a superficial comparison between the franchise under consideration and offerings by other franchisors could lead to the erroneous conclusion that the cost of he franchise is excessive. As a result, potentially good prospects could be ost. It is better, therefore, to break down the overall price of the package nto its individual components so that prospective franchisees can make neaningful comparisons.

Level of total investment

Given the wide variety of franchises on offer and the variables in the infrastructure, it would be meaningless to state an average investmer figure. What practical purpose would it serve to compare the cost of setting up a hotdog stand with the investment needed to establish a McDonald’: drive-through restaurant? The Franchise Book of Southern Africa lists wide range of opportunities requiring total investments ranging from less; than R50 000 to over R2 million, and this may be a good place to start your investigation.

Financing a franchise

To establish a franchise network or to purchase a franchise requires a significant investment. Unless this new venture can be financed entirely from your own cash resources, you will need to approach your bank for a loan or find another source of capital. It often happens that new entrepreneurs are unfamiliar with the various options that are available to them, leading to flawed decision-making, lost opportunities and worse. To assist readers in this regard, a brief section on small business finance follows.

Types of finance

Newcomers to the business world are frequently surprised to learn that it is not enough to ask a banker for finance. He will expect you to know that different finance vehicles exist, and to ask for the correct one. The most common forms of finance will be listed below:

Own cash resources

Your ability to invest some money of your own into the venture is a prerequisite. You cannot expect a financier to invest in your small business unless you are willing and able to do the same.

Family and friends

Loans by family and friends are often called soft loans, because no interest is payable and / or no fixed repayment period has been agreed. Manybusiness start-ups have been financed in this way and have grown to a size where traditional forms of finance could be tapped. But cases have been reported where essentially sound businesses with a bright future ahead of them have failed because of the way an informal loan had been structured. Either the investors demanded a disproportionate amount of influence over the way the business should be run, or internal quarrels prompted them to ask for their money back before the business could afford it. A properly drafted loan agreement reflecting the respective rights and obligations of lenders and borrowers will eliminate such problems.

Partnerships and joint venture partners

In terms of a partnership, the partner becomes a co-owner of the business. In addition to making an investment, he will become jointly and severally liable for some or all of the obligations of the business and will be entitled to a share of the profits in return. In a small business context, partnerships work best if the partner brings some expertise to bear that has been lacking in the past.

Overdraft

An overdraft is a form of loan that is granted, usually by your bank, for a short period. Once an overdraft limit has been authorised, you are able to draw on your bank account, up to the agreed limit, just as if you had the money in the bank. Your bank is likely to charge you a facility fee for making the overdraft available, plus daily interest on the actual debit balance.

Overdrafts are short-term loans and should fluctuate; the bank’s expectation will be that your account shows a credit balance at least some of the time. You should be aware that your bank could call up an overdraft at relatively short notice, usually inside one month. For this reason, overdrafts should only be used to bridge seasonal valleys in a business’s cash flow and not to finance major investments that are of a long-term nature.

Letter of Guarantee

Vhen setting up a new business, its owners will be asked to pay various deposits, for example for rental of premises. To conserve scarce cash serves, a Letter of guarantee issued by a bank can be offered instead.

Once again, the bank is likely to levy a facility charge, but this should be less than the interest charge on an overdraft.

Loan capital

If your business requires a cash infusion over the medium term, you can approach your bank with a request to grant you a term loan. Such loans are usually offered for periods of between 36 and 60 months and are repayable in monthly instalments, to which interest will be added. Before a loan application is approved, the bank will expect you to present it with a loan proposal that is backed by a detailed business plan. On approval of your application, the bank will enter into a written loan agreement with you that will contain the agreed terms and conditions for the loan.

You should be aware that, should you fall behind the agreed payment schedule, your bank would have reserved the right to call up the entire balance of the loan at once. Your attempts to have this clause removed are unlikely to be successful, your best protection against such an event would be to maintain close contact with your banker.

Subject to the terms of the agreement you have reached with your bank, loan capital can be used to finance the purchase of equipment, furniture and initial stock, or even to bolster working capital reserves. Interest rates are generally more favourable than those charged for overdraft finance. The downside is that the period of a term loan is fixed and you will pay interest on the outstanding balance even though your current account may be in credit.

Asset finance

The purchase of expensive items of equipment and vehicles can be funded through some form of asset finance. The main options of asset finance are:-

n Instalment sale. This is a credit agreement in terms of which the item to be purchased is bought by the bank and then sold on to the customer. Payment takes place over a negotiated period, in the form of agreed monthly instalments to which interest will be added. Ownership of the item rests with the bank initially, but once the final payment has been made, it passes over to the customer. (This form of financing was previously known as hire purchase.)

Rental agreement. Businesses that need to replace certain items on a regular basis may benefit from rental agreements. It may be possible to keep monthly payments relatively low by taking the residual value of the item into account. The customer enjoys the uninterrupted use of the item for a predetermined period, but never gains ownership. By way of illustration, it could be said that such an arrangement is not unlike renting a flat.

Financial lease agreement. The customer enjoys the uninterrupted use of the item, but at the end of the agreed period, he has an option to acquire ownership, usually against the payment of an amount that is equal to the item’s residual value. As lease charges are fully tax deductible, the use of this form of financing may, subject to individual circumstances, result in significant tax advantages.

All forms of asset finance can be structured to the needs of the business, taking the expected usefulness of the underlying asset into account. Repayment periods range from 12 to 60 months, and a deposit is usually payable. The finance house or bank will generally secure the loan by retaining ownership over the fixed asset and by requesting personal guarantees.

Factoring

Manufacturing or distribution businesses that supply other businesses on credit terms and have substantial turnovers can free up their cash flow, at a price, by “selling” their debtors book to a discounter. Depending on the perceived quality of the book, the discounter will advance up to 75% of the outstanding amounts upfront and pay the balance upon receiving payments from debtors, naturally minus his fees.

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