Why funding failures sink franchises

Ethel Nyembe, head of small enterprises at Standard Bank.
Ethel Nyembe, head of small enterprises at Standard Bank.

Cape Town – Franchise opportunists who don’t do their homework before venturing into this sector will fall horribly short, according to a Standard Bank executive.

“They don’t necessarily do their homework around why they want to get into that particular franchisor or franchisee,” Ethel Nyembe, head of small enterprises at Standard Bank, told Fin24.

“Most of the time, they choose one that they … use on a daily basis or they quite like, without understanding what the real … factors that they need to consider from finance, how it performs, and talking to other people that are have those franchisees.”

Funding is one of the most important critical of this process.

Nyembe said there were various ways people could get funding for a franchise.

Friends and family

“Many potential franchise owners turn to family and friends for finance,” said Nyembe. “This is one of the most common forms of financing a business, but should be undertaken with caution.

“Family relationships can be tested and even destroyed if the undertaking does not thrive as planned. Even though franchises have a much higher success rate than start-up SMEs, there is no guarantee that they will prosper.”

She said two factors should be considered when approaching family or friends for loans:

- The unstructured nature of family loans can cause future problems. Often, money is lent on the understanding that it will be repaid - with or without interest - but no repayment date is set. This can lead to resentment on the part of the lender and disputes.

- If loans are accepted from a number of family members, keeping track of the repayment terms for each could be challenging. It is therefore important that all agreements are put in writing.

Listen to the full interview:

Interview by Matthew le Cordeur.

A business partner

Finding a business partner to invest in the franchise and take a stake in its future is a viable financing alternative.

“A partner should share your values, passion and determination to make the franchise succeed,” said Nyembe. “All aspects of the partnership agreement, share allocation and profit sharing should be placed in contractual form, so that future misunderstandings do not occur.”

Loans

Financing a franchise through debt equity (a business loan) is often the best option, as there are a few valuable advantages:

- The banker will probably know the franchisor, the brand and the history of the organisation.

- The bank may already have an association with the franchisor and understand the fee structure required.

- The advice you receive will ensure that there are no ‘unpleasant surprises’ waiting, regardless of whether the franchise is an established outlet or a proposed new outlet.

Realities of bank method

Although banks are in the business of lending money, the potential franchisee must understand that they are also concerned with minimising risk. When approaching a bank for funding, Nyembe said you must realise:

- It is unlikely that any bank will agree to supply 100% of the funding required.

- The more money you have committed to your venture, the more likely it is that you will get a loan. Banks are more comfortable to grant loans to people who are committed to their businesses.

- Security is important. Providing a bank with security for the loan in the form of assets or sureties increases the likelihood that loans will be extended.

“The advantage of bank loans is that repayment terms and interest rates are agreed upon up front. This helps to regulate cash flow, as the repayments will be calculated on a monthly basis for the period of the loan,” she said.

There are also several methods of financing that should be avoided when seeking funding, cautioned Nyembe. These include:

Excessive borrowing

One of the most common mistakes made by franchisees is to borrow the funds to make up the unencumbered deposit required by franchisors, explained Nyembe.

“Franchisees should remember that their business is not going to be profitable immediately. They are bound to experience slow months especially at the beginning of their business venture.

“In this instance, the higher their loaned percentage of capital, the more pressure there is on the business to repay the loan instead of being able to redirect any profits back into the business to build equity.”  

Double indebtedness

“Although there are many forms of loans that the franchisee can have access to, they do come with their fair share of pitfalls,” she said.

“Double indebtedness is the result of a franchisee using a loan to fund the unencumbered portion of their contribution as well as taking out a loan to finance the remaining portion of the capital needed to start the business.

“Utilising a personal credit card can prove to cause more harm than good as this will create a secondary, more costly debt for the franchisee. Servicing two loans at the initiation of the business can place the business and the franchisee under undue strain.”

Raiding your home loan

“Servicing the unencumbered portion with one’s home loan is risky as one could lose the equity in the house, extend the repayment term, and have to pay a higher amount on the mortgage.

“This will result in a high personal debt as well as a high business debt if a business loan is utilised by the franchisee. With the rise of interest rates, a franchisee’s house and business could be at stake.

“Starting a franchise operation with massive debt hanging over you is not advisable,” said Nyembe. “If the franchise outlet is new, it could take several months before the business is established and the turnover is able to finance operations and costs. It is during this period that you and your business will be most vulnerable to financial failure.

“Avoiding this means doing your homework, knowing exactly how much money you will need and then financing it in a responsible manner.”

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