The pros and cons of financing your franchisees in business. Should you fund your franchisees?

This question is one that generally arises in the case of more mature networks or larger corporate networks looking to expand their business model to include a franchised component. For many emerging franchise networks, it contradicts the rationale for choosing franchising as their expansion strategy.

The strength of the franchise model is that it provides an entrepreneur with the two fundamental requirements to grow their business – capital and people. So let’s examine the more traditional franchise model and then look at variants that include other funding options.

Franchising as a capital raising strategy

Franchising creates access to the capital to grow. Banks can be reluctant to loan to small business, generally requiring personal assets as collateral and imposing high interest.

Franchisees contribute the capital to grow your brand, unit by unit. They commit the establishment costs, a franchise fee for access to your intellectual property and the working capital which is interest free to the network and does not reduce your equity or control.

Franchising as an HR strategy

Franchising also creates access to the human capital to grow, bringing motivated owner operators to run each unit. Having committed their capital, often secured by the family home, they then commit on average seven years to your network. A well recruited and supported franchisee can outperform a company owned and operated outlet in both sales and profitability by driving sales, managing costs, training their employees and engaging consistently with their customers.

What circumstances might lead a franchisor to fund their franchisees?

Importantly, should you do this? What are the commercial, legal and operational considerations? How do you mitigate risk? Let’s look at the pros and cons.

Cost as a barrier to entry

One of the major reasons some franchisors provide particular forms of funding assistance to franchisees is that the costs to open an outlet are so high it reduces the number of otherwise good candidates you can recruit.

Big box retailers, medical-related clinics, recreation centres and motor showrooms are a few such models where the initial investment may be from $750,000 upwards of $1.5 million or more, thereby creating a real barrier to entry for many prospective franchisees. Even more modest investments in retail or foodservice franchises may exceed the ability of a good candidate to fund the capital required to establish the business.

There are a few ways to address this issue:

1. The joint venture (JV) franchise model

This is where the franchisor and franchisee set up a new franchisee entity to enter into the franchise agreement (and any leases, supply arrangements or other legal agreements). This is subject to a shareholders’ agreement and is often a 50/50 percentage deal (but can be 51/49 percent or any other split agreed by the parties) for the duration of the term.

Each shareholder invests the required percentage of funds, goods or fit out to equal their designated share. In most cases the recruited franchisee partner then runs the business on a day to day basis with the franchisor/franchisee partner being more of a silent partner operationally.

They meet in their capacities as franchisee partners regularly to discuss the management and performance of the business. This is quite distinct from any relationship and meetings between the parties as franchisee and franchisor.

The advantages are clear but so are the potential difficulties. The challenge for the franchisor is maintaining a genuinely differentiated role as a franchisee partner from their role as the franchisor. How the partnership will operate from a legal perspective should be enshrined at commencement in the shareholders’ agreement.

This is a standard commercial agreement, totally separate from the franchise agreement and should include very clear terms and conditions to manage a dispute or exit by either party.

However even when you do manage this commercially and operationally, it is difficult for the franchisee to avoid the perception of a power imbalance in the franchise relationship, especially when there is a dispute, a breach, or in the worst case, a termination of the franchise agreement by the franchisor.

There could also be a degree of difficulty in dispute resolution from mediation to litigation in ensuring there was no perceived or actual conflict of interest between the partnership relationship and the relationship under the franchise agreement.

Laser Clinics Australia (LCA) has managed the JV model well with the franchisor recruiting and partnering with good owner operators who were able to get into their own business at a manageable cost. The financial model and legal agreements were developed in 2011 and 2012. LCA now has 88 clinics Australia wide and sold to KKR Capital in August 2017 for more than $600 million*.

2. The JV with equity buy-out franchise model

This is similar to the JV model in reducing the barrier to entry for many otherwise good franchise candidates. There is a shareholders’ agreement and the parties set up an entity to operate the franchise under the franchise agreement. The difference is the deal allows the recruited partner to buy out the franchisor partner over time and own up to 100 percent of the business.

This is particularly effective if there is greater inequity in the original shareholding (say 80/20 favouring the franchisor partner) as it provides an excellent incentive for the junior shareholding partner to work hard and buy out the franchisor partner.

The challenges relating to the perception of an imbalance of power and resolving disputes outlined in the JV model remain, but obviously diminish as the buy-out progresses. Some franchisees might also feel it is fairer but the buy-out option will obviously be tied to the return on investment for both partners.

Targeted financial modelling will allow the franchisor to model the returns and the pay back periods for the respective partners over the course of the franchise term and calculate what is commercially feasible before entering into this model.

EyeQ Optometrists is a optometry network of about 26 practices in five states that launched its franchise model in 2014 following several years of developing systems. It applies the JV equity buy-out model very successfully for some of its practices to assist young optometrists. These include employees, whom EyeQ has mentored clinically and developed commercially in its existing practices, who are helped to setup and operate their own franchised practices.

The young optometrist builds the practice over the first few years of the JV franchise grant, developing a sound financial track record for the business. From that point banks will generally fund them to take over ownership, re-paying the franchisor partner who can then go on to assist another upcoming optometrist become a franchisee under the same model.

This works particularly well as the partnership facilitates ongoing professional and business mentorship by the franchisor, not only in the traditional franchisor role, but in a more hands-on relationship as franchisee business partners in the first crucial couple of years.

3. The JV funds guarantee franchise model

This is similar to the other JV models, but in this case the franchisor procures all the funds to establish the franchise and partners with the franchisee to operate the business in a shareholding partnership under the franchise agreement. Again the recruit operates the business and may or may not have an equity buy-out option.

The key here is that the franchisor provides the strong supporting guarantee to the bank or lender for the funding provided to finance the establishment and operation of the franchise. The joint-venture franchisee company is then responsible for the loan repayment and the success of the business with both partners providing guarantees to the lender.

While the advantages for the recruit are clear, this model has a higher degree of risk for the franchisor in guaranteeing the loan funding. However, the JV allows the franchisor (as a franchisee partner) a means of mitigating the risk in some measure with their more hands-on role in overseeing the management and monitoring the performance of the business.

Aside from the obvious risk in guaranteeing loan funding and the business failing there is another attendant risk. This may occur in the event of a serious dispute, a breach or termination of the franchise agreement where the relationship sours.

There is the possibility the franchisee may claim that the loan funding – raised and guaranteed by the franchisor – was an inducement to enter the business. That their ability to take independent business advice was compromised or worse that representations made about the business in conjunction with the provision of funding on that basis may have been deceptive and misleading.

Take expert legal and commercial advice on how you set this up and what representations are made during recruitment.

Auto Brake Service (ABS) is a well-known example of a franchise network developed a couple of decades ago who used this model to great effect. The franchisor procured lender funding, providing a guarantee for the bank loan on principal and interest typically over seven years. It then set up a JV franchisee entity with an optional buy-out with existing employees to open new franchised locations operated by the former employee, now franchisee. ABS was very successfully acquired by Metcash about five years ago in a multi-million dollar acquisition and continues as one of Australia’s leading automotive service networks.

Context to providing franchisee funding

So while there are circumstances where the franchisor may fund franchisees – it is all about the context. Simply providing the capital because you can, could expose you to unnecessary risk and even worse, defeat one of the major determinants of your network growth and success.

Franchising is a very successful growth model in part because franchisees invest their own capital and take loans secured against their own assets in the business. It is the ‘skin in the game’ that ensures their focus as owner operators on managing the business to optimal profitability. This is the heart of entrepreneurship and can be a qualifier to entering your network. Otherwise they may have little more incentive than employees to do what it takes to succeed.

A few other issues to consider about funding franchisees

Be mindful if you are considering these models that they can be both complex to manage and time consuming. Yes, you will be rewarded when the business becomes profitable and when it is sold because you own a share of the enterprise value the franchise is creating. But what is your funding capacity to contribute or back your guarantee, and how much operational bandwidth do you have?

Even a monthly partnership meeting to go over the financial data, employee and other operational issues and to discuss and approve local area marketing for example, has to come from the time you could be spending managing and supporting your network as the franchisor. And then multiply this by how many franchisee partnerships you have. Additionally, every business has a limit to their borrowing capacity.

Having taken part in disputes between franchisee partners of the JV model, remember that the more complex relationships are, the more likelihood of misunderstanding and dispute. And with the best will and agreements in the world, resolving disputes can be costly both financially and reputationally, taking focus away from growing your business.

When you shouldn’t fund your franchisees

I have also had franchisors and those considering franchising talk about funding and the JV model because they want more control over their franchisees. Some would like to secure part of the franchisees’ business for commercial reasons. Yet others feel their franchisees would do better with the greater hands-on franchisor involvement (as franchisee partner) that a JV offers.

The franchise relationship under the over-arching Franchising Code of Conduct already provides the franchisor with all the control and growth mechanisms you need to articulate the model, screen, recruit, induct, train, support, enforce compliance and innovate against future changing markets. Your operations manuals should clearly delineate your respective responsibilities, so with good head office systems and governance, control and compliance should not be an issue. Additional protection is provided by expertly drafted franchise agreements and other legal documentation, such as supply agreements, IP deeds and sub-leases or step-in deeds.

Owning part of the franchisee’s business for simply commercial reasons is not viable for either party. You need to model your single unit prototype/s to ensure the returns for franchises, and you need to model the network returns to ensure you can meet the costs of running the network.

There are no limits to the franchisor owning and operating as many corporate outlets as it can afford to open and manage. Owning the online business and elements of the supply chain can also provide additional revenue channels.

Finally, it is intended that well recruited and trained franchisees will be capable of running their businesses independently of the franchisor who provides support, not daily hand-holding. So funding under any model is not the answer to concerns about controlling franchisees, increasing your revenue or providing day to day support in perpetuity.

Assess franchise funding risk

Providing funding assistance to franchisees in any format carries risk which needs to be assessed thoroughly and contained in measured balance with the returns to you and your franchisees. It is entirely about the context, so consult an expert to guide your through this complex exercise.

*DC Strategy developed the franchise programs, franchise financial models and/or drafted the franchise disclosure documents and franchise agreements of the clients mentioned in this article.