When embarking on any major life change, there is always one constant that’ll make or break your decision—money. Getting into the business of franchising is no different. If you’re considering buying a franchise, there are a few key financial issues that you need to assess before diving in.
Understand your working capital needs to get the business profitable
“You need to financially understand the total cost beyond what is in the Item 7,” said Sean Fitzgerald, chief development strategist at No Limit Agency.
Although Item 7 lists the total initial investment, you need to look at the very bottom—that’s where it says that you have to have an additional three months of working capital. If it takes you six months to a year to break even, your initial investment is going to be much higher.
If you ask a franchisor when the typical break-even point will come and they don't have an answer, you’ll need to speak to several franchisees to get a better understanding of how much capital you need to carry you through to profitability. During your due diligence period, this is a question you should be asking the franchisees to gain a better grasp on the financial performance of the individual units.
“The biggest mistake in franchising comes if you don't understand the importance of working capital,” Fitzgerald said. “Most good franchisors will explain that you need additional funds for those first few months, but don't assume that the number listed in Item 7 is all that you need.”
Banks don’t understand franchising, so you need to educate them
“If you're going to the bank for a loan, you will quickly learn that many banks don't understand franchising,” Fitzgerald said. “Therefore, you're going to have to educate the bank on how franchising works.”
Typically, the lender at the bank will first look at your background. If it’s not in sync with this new business venture, there is a high probability that they will deny your loan. Lenders that don't regularly work with franchising have trouble understanding the franchisor and franchisee relationship—you don’t necessarily need the right resume to succeed in franchising.
Mike Rozman, the co-president and CEO of BoeFly, the premier online marketplace connecting small business borrowers with lenders, agrees.
"We work with a lot of franchisees that are financing their investment for the first time,” Rozman said. “One thing that we think is really important is that they work with a lender that understands how franchising works. If the bank doesn't understand franchising, it can be an extra challenge for the potential franchisees.”
BoeFly is dedicated to helping potential franchisees better understand their economic circumstances while still in the discovery phase, through the use of bQualTM, which provides individuals with vital financial details, such as their business credit score (SBSS by FICO) required by the Small Business Administration and a consumer credit score, in addition to a fundability report assessing their loan prospects.
“When franchisees have the same data that banks will use to judge them right up front, then they’re positioned to succeed,” Rozman said.
Understand that not all franchise brands are created equal. Then, focus on your specific industry category.
“A rule of thumb is that EBIDTA at 10 percent is good, but 15 percent or higher is ideal,” Fitzgerald said.
Take time to review what businesses that are competitive in your space are making. It’s difficult to compare the return on investment numbers for all brands because you simply can’t lump different types of businesses all together. Because the investment level of a quick service restaurant in a mall is different from the investment level of a full service restaurant in a stand-alone brick and mortar space, you shouldn’t expect to make the same amount. A home-based or mobile business is also a completely different type of concept, so your ROI is going to be different. When looking at how much you can make and the time frame, you have to compare within industry categories.
"Don't get wrapped up in average unit volume numbers,” Fitzgerald said. “The most important number is profitability or EBIDTA. If no one is making money, it's not a good investment, and you need to dig around in your validation calls with current franchises to gauge this.”