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Capital Formation Strategies For the Growing Franchise

One of the most difficult tasks faced by the leadership team of a growing franchisor is the development and maintenance of an optimal capital structure and access to the resources that the franchisor will need to stay strong and maintain its growth plans. Access to affordable debt and equity capital continues to be a problem for the growing franchisor even though franchising has matured as a viable method of business growth.

Only recently have the investment banking, private equity, venture capital and commercial lending communities given franchising the recognition it deserves. There are finally enough franchisors whose balance sheets have become more respectable, who have participated in successful public offerings, who have played (and won) in the merger and acquisition game, and who have demonstrated consistent financial appreciation and profitability. These developments have played a role in providing young franchisors access to affordable capital in recent years.

Nevertheless, a growing franchisor must be prepared to educate the source of capital as to the unique aspects of financing a franchise company. And there are differences. Franchisors have different balance sheets (heavily laden with intangible assets), different allocations of capital (primarily as expenditures for “soft costs”), different management teams, different sources of revenues, and different strategies for growth. The amount of capital potentially available, as well as the sources willing to finance a franchise, depends largely on the franchisor’s current and projected financial strength, as well as the experience of its management team and a host of other factors, such as trademarks and its franchise sales history.

The Initial and Ongoing Costs of Franchising

Before examining the capital formation strategies which may be available, you should understand the specific nature of the capital requirements of the early-stage and emerging franchisor. Although franchising is less capital-intensive than is internal expansion, franchisors still require a solid capital structure. Grossly undercapitalized franchisors are on a path to disaster because they will be unable to develop effective marketing programs, attract qualified staff, or provide the high-quality ongoing support and assistance that franchisees need to grow and prosper.

Bootstrap franchising has been tried by many companies, but very few have been successful. In a bootstrap franchising program, the franchisor uses the initial franchise fees paid by the franchisee as its capital for growth and expansion. There is a bit of a catch 22, however, if the franchisor has not properly developed its operations, training program, and materials prior to the offer and sale of a franchise. Such a strategy could subject the franchisor to claims of fraud and misrepresentation, because the franchisee has good reason to expect that the business format franchise is complete and not still “under construction.” A second legal problem with undercapitalization is that many examiners in the registration states will either completely bar a franchisor from offer and sales in their jurisdiction until the financial condition improves, or impose restrictive bonding and escrow provisions in order to protect the fees paid by the franchisee. A third possible legal problem is that if the franchisor is using the franchise offering circular to raise growth capital, then the entire scheme could be viewed as a securities offering, which triggers compliance with federal and state securities laws.

The start-up franchisor must initially put together a budget for the developmental costs of building the franchise system. The start-up costs include the development of operations manuals, training programs, sales and marketing materials, personnel recruitment, accounting and legal fees, research and development, testing and operation of the prototype unit, outside consulting fees, and travel costs for trade shows and sales presentations. Naturally, there are a number of variables influencing the amount that must be budgeted for development costs, including:

  • The extent to which outside consultants are required to develop operations and training materials
  • The franchisor’s location and geographic proximity to targeted franchisees
  • The complexity of the franchise program and trends within the franchisor’s industry
  • The quality, experience, and fee structure of the legal and accounting firms selected to prepare the offering documents and agreements
  • The extent to which products or equipment will be sold directly to franchisees, which may require warehousing and shipping capabilities
  • The extent to which personnel placement firms will be used to recruit the franchisor’s management team
  • The use of a celebrity or industry expert to “endorse” the franchisor’s products, services, and franchise program
  • The difficulty encountered at the United States Patent and Trademark Office in registering the franchisor’s trademarks (franchise law information)
  • The extent to which direct financing will be offered to the franchisees for initial opening and/or expansion
  • The compensation structure for the franchisor’s sales staff
  • The difficulty encountered by franchise counsel in the registration states
  • The extent to which the franchisor gets embroiled in legal disputes with the franchisees at an early stage
  • The quality of the franchisor’s marketing materials
  • The type of media and marketing strategy selected to reach targeted franchisees
  • The number of company-owned units the franchisor plans to develop
  • The length and complexity of the franchisor’s training program
  • The rate at which the franchisor will be in a position to repay the capital (or provide a return on investment), which will influence the cost of the capital.

About the Author

Andrew J. Sherman is a Partner in the Washington, D.C. office of Jones Day, with over 2,500 attorneys worldwide. Mr. Sherman is a recognized international authority on the legal and strategic issues affecting small and growing companies. Mr. Sherman is an Adjunct Professor in the Masters of Business Administration (MBA) program at the University of Maryland and Georgetown University where he has taught courses on business growth, capital formation and entrepreneurship for over twenty (23) years. Mr. Sherman is the author of twenty-three (23) books on the legal and strategic aspects of business growth and capital formation as well as Road Rules Be the Truck. Not the Squirrel. which is an inspirational book published in the Fall of 2008. His twenty-third (23rd) book, Harvesting Intangible Assets, Uncover Hidden Revenue in Your Company’s Intellectual Property, (AMACOM) is due out in the Fall of 2011. Mr. Sherman can be reached at 202-879-3686 or e-mail ajsherman@jonesday.com.

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