By: Randy Evans
Krass Monroe, P.A.
Navigating the financial aspects of franchising can be tricky for those new to the business model. As attorneys for franchisees and franchisors, we have seen it all, from lapses in judgment to serious miscalculations. The following are my top 10 common financial mistakes made by new franchisees in the early stages of buying and operating a franchise business:
1. Failing to understand the legal and financial obligations contained in the franchise disclosure document (FDD), the franchise agreement, any accompanying development agreement and other related franchise contracts. It is prudent to spend a little money on the front end to obtain advice from legal and financial advisers who have experience in franchisingit will help you understand the legal and financial obligations of the franchise relationship.
2. Underestimating the build-out and other opening costs in connection with starting up a franchise business. It is important to have a good handle on all of the costs that will be incurred in order to ensure that you have arranged for appropriate levels and sources of financing.
3. Underestimating the working capital needs of the business, particularly in the initial start-up phase. It is critical not to run short on working capital as you work to establish the business.
4. Not understanding how the royalties, advertising funds and other required payments will be calculated and collected by the franchisor. These represent significant costs of operating a franchise business, and must be accounted for in your business plan.
5. Overleveraging the business. It is important to have the proper capital structure, including an appropriate level of equity capital, to ensure the cash flow of the business is sufficient to satisfy all debt and other obligations. This is less of a problem in the current credit environment, as lenders are insisting on higher levels of equity contribution by the owner.
6. Not properly planning for future capital needs, including remodeling, re-imaging, new equipment packages and other financial needs in order to comply with franchisor requirements and keep the business fresh and current. It is important to set aside a reserve fund or make other arrangements to fund them.
7. Undervaluing your personal liability as the owner in connection with franchise agreements, leases, bank loans and other aspects of the business. It is common for the franchise owner to be required to personally guarantee all of these types of obligations of the business, and it is important to understand both the scope and nature of these personal liabilities.
8. Not properly documenting partnership or similar relationships. It is important to think about and provide for voting, buy-sell and related issues on the front end of starting the business in order to avoid timely and costly disputes further down the road.
9. Misjudging the time commitment required to make the business successful, especially in the first year. Starting a franchise business takes an enormous commitment of time and energy on the part of the franchisee, and it is important to understand that before committing to a long-term franchise relationship.
10. Viewing the franchise as a short-term business opportunity, with the option of selling the business as an easy exit strategy. Most franchise agreements run for a minimum of 10 to 20 years, and any sale is contingent on approval of the new owner by the franchisor. It is important to understand the long-term nature of franchise relationships and to plan accordingly.
Understanding and avoiding these common mistakes can make the difference between success and failure when buying and operating a franchise business. It all comes down to proper planning, knowledge of franchising and strategic use of your professional advisors.
For more information on this issue, Randy Evans, or Krass Monroe P.A., visit the International Society of Primerus Law Firms or krassmonroe.com.