Accounting for Franchises

Franchises are certainly big business in Australia with recent studies suggesting they contribute $128 billion to the economy. The franchise concept attracts a lot of first time business owners because you are basically buying someone else’s business or brand together with all their systems, processes and marketing collateral. The general perception is that franchising is a very successful form of small business in Australia, however, some statistics from a study in 2008 suggests that:

- Only 81% of franchisees are profitable
- 58% of franchisees generate a profit of less than $50,000 per annum
- 3% of franchisees generate a loss of more than $50,000

Buying a franchise is often described as buying a ‘business in a box’. It sounds like a recipe for success but it's not that simple. In the space of just 24 hours in October 2011 nearly 400 Australian franchisees operating under the Refund Home Loans and Tyrecorp brands were hit with the news that both companies had collapsed. The eight year old mortgage broking group Refund Home Loans with around 350 franchisees had been placed in administration while tyre retailer and distributor Tyrecorp with 33 franchisees was up for sale after being placed in receivership.

Clearly, buying a franchise doesn't guarantee financial success and franchise groups are not immune from the risks we associate with buying any type of business. We urge you to consult with an accountant who has considerable franchise experience and a solicitor who is familiar with Australian franchise laws because of the legal red tape associated with franchise agreements.

Remember, product development, production processes, branding and marketing are all there on a platter waiting for you to serve up to the public but tougher lending criteria and reduced risk tolerance from the banks can make obtaining finance difficult. You need to identify your set up costs and banks will demand budgets and cash flow projections plus possibly a business plan before they lend you money. Generally, franchise fees range from as little as $35000 for a mowing business to as much as $1 million or more for a McDonald’s restaurant and it is important to establish what the franchise fee includes. Normally it covers licensing costs (use of franchise name), rights to use systems, training costs, support, software requirements and site selection. There may be additional costs for the shop fit-out (including furniture, signage, fittings etc) plus inventory (stock) and other supplies (office supplies and disposable supplies such as napkins, possibly utensils and cups for food services). When preparing your budget and forecasts don’t forget to factor in legal and accounting advice, recruitment costs, insurances, WorkCover and finance repayments if applicable. Franchisees can also be required to pay ongoing support fees which may be a fixed monthly amount or calculated as a percentage of gross turnover. There may also be a franchise renewal fee.

The benefits of the franchise model include:

Capitalising on existing brand awareness
Management experience with proven success
Marketing, administration and strategic support from ‘head office’
Being part of a large group provides buying power for supplies and marketing
Pre-established business systems with ongoing support
Designated geographic territory
Bank finance is often easier to obtain for a franchise rather than starting a business from scratch (note that some banks prefer certain franchises)

Some of the franchise ‘cons’ to consider would be:

Royalty fees payable to the franchisor eat into your profits
Reduced freedom in decision making
Franchisors often control the pricing of key supplies
Upfront franchise fees and significant start up costs
Franchise fees calculated on sales turnover, not profitability
Most franchisors charge a significant start-up cost with the median retail start-up fee around $275,000

WHAT EXACTLY IS A FRANCHISE?

A franchise is an agreement or license between two parties where the franchisee (which can be a person or group) is given the rights to market a product or service using the trademark of the franchisor. The franchisee is obliged to pay the franchisor certain fees and royalties for the rights to market the product (or service) in Australia. In return, the franchisor has the obligation to provide these rights and generally support the franchisee. Therefore, the franchisor and franchisee have a strong vested interest in the success of the brand.

Typically there are two types of franchises, namely ‘business format franchising’ and ‘product and trade name franchising’. Business format franchising is very common in Australia and applies to industries like child care, fast food restaurants, automotive services, real estate, cafes, education, convenience stores, hairdressers etc. This format provides the franchisee with the use of trademarks and logos plus provides a turn key system for operating the business. The franchisors assist the franchisee with site selection, interior layout and design, hiring and training, advertising and marketing, product supply and more. In return, the franchisee pays an upfront fee and agrees to pay continuing royalties that help the franchisor provide research, development and support for the entire franchise system.

HOW MUCH DOES A FRANCHISE COST?

Prices vary dramatically with some franchises including a large shop fit out together with equipment while others just include the bare bones.

It is possible to find franchises under $30000 but it is important to do your homework. The general rule of thumb is that you should spend one hour of research for each $1000 you invest in a franchise. Therefore a $60000 franchise opportunity deserves 60 hours of research and education prior to purchase. To put this in perspective, it’s only a week and a half of full time work and there is a lot at stake. Proper due diligence could take months and you might consider meeting with current or past franchisees and get their feedback. If it is consistently negative, you obviously need to be very cautious about investing in that franchise.

When valuing a business or franchise there are some basic valuation guidelines. Business values are generally based on an EBIT (Earnings before Interest and Tax) of 25% after providing the business owner with a fair salary. For example, let’s assume your business earnings (before interest and tax) is $100000 before paying you a salary. If a fair salary for the business operator is $60000 per annum then the business has an EBIT (after your salary) of $40000. If you are looking for a 25% return on your investment then a fair price for the business is $160000 (because a 25% return on a $160000 outlay is $40000 per annum).

These are obviously just guidelines because we see businesses bought and sold with much lower EBIT’s (particularly for lower cost businesses) and sold with EBIT’s above 30%. Factors that will influence the potential return and the price of the franchise include:

How long the franchise has existed and how many franchisees are operating
Whether you are buying an existing franchise or opening a new site
The risk associated with the industry (food, child care, hairdressing etc.)
The total price of the franchise business
The initial term of the contract and renewal options

Most importantly, your calculation of the business’ EBIT and therefore the value should be based on profit and loss projections you prepare. If you are buying an existing business you should have access to historical financial statements and other figures prepared by the vendor. If you are buying a new franchise, you are probably relying on some forecasts and projections prepared by the franchisor. In either case, whatever figures you receive should be taken as a guide only. It is vital that you prepare your own detailed projections (month by month for at least the first twelve months) to work out what profit and EBIT you will make.

The figures provided by the vendor or franchisor may exclude costs such as interest on borrowings, depreciation, motor vehicle expenses, the owner’s wage and income tax. It will obviously be historical data and does not tell you how the business will perform in the future. Generally speaking, your projections and forecasts should form the basis of your decision to buy a business or franchise.

Franchisors must abide by the Franchise Code of Conduct which includes key areas of disclosure, dispute resolution and franchisee rights. Franchisors have been known to provide projections of your earnings, however, these are sometimes misleading. Below are some basic questions that should be asked when reviewing earning projections:

Are the figures based on gross sales only or do they include GST or are they net of actual costs as well?
Is it based on average incomes?
Are all franchisees included in the projection? (under performing franchisees may have been omitted)
If you removed the top 10% of the franchisees would the figures change dramatically? In other words, are there a small number of high performers inflating the figures?
Are there any Company owned franchises? These may have different or discounted costs
What is the break even point and when I can expect a return on my investment? Often franchise agreements run for 5 years without a guarantee of an extension. You need to calculate what your return on investment would be at the end of the term in case you have to walk away.

GET ADVICE

We demand that franchise agreements be perused by a professional, preferably a solicitor and an accountant who has franchise industry expertise. Unfortunately, many franchisees don’t really understand what they are buying into and get upset when they realize they are obliged to pay ongoing monthly advertising and marketing fees. These costs are clearly spelt out in the agreement but often new franchisees are so eager to buy that they don’t seek professional advice and ignore the fine print in the contract. This misunderstanding can also drive a wedge between the franchisee and franchisor from the outset.

The ACCC received 645 franchising complaints in 2011, almost half of those on contractual issues. Franchisees need to understand that the franchise agreement will terminate at some point in time. The contract will probably provide options to renew but we always recommend you start your business with the end in mind. In other words, your tax structure needs to factor in the potential discount capital gains tax concessions and the possible admission of new partners. You also need to understand your rights regarding on-selling your franchise or business to a third party and be clear about your choices at the end of each option. Franchisees who don’t do their homework and receive sound legal advice can be left in a vulnerable position when a franchise agreement ends. Despite potentially investing several hundred thousand dollars to buy into the business, some franchisees ignore the other end of the transaction, the sale. Buyer beware is the message and we still hear horror stories from franchisees who say, “We were simply unaware that this could happen” when it was clearly spelt out in the contract.

LEGISLATIVE REQUIREMENTS

If you are thinking of buying a franchise, you should also familiarise yourself with the legislative requirements. A franchisor must give a potential franchisee a disclosure document at least 14 days before the new franchisee enters into the franchise agreement. The contents of the disclosure document are set out in the legislation but in terms of the financial aspects it will cover the following:

Provide an estimate of the total costs to establish a franchise (Section 13)
Provide details of ongoing payments to the franchisor (Section 13)
Provide some information about financial performance (Section 19), however, franchisors can elect not to disclose any information
Provide a summary of the most recent financial statements of the franchisor (Section 20) or alternatively, the franchisor can provide a statement verified by a registered company auditor that the franchisor is able to meet its debts as and when they fall due.

THE TRAPS

While some franchisors market their franchise as a simple 'turn key' operation, running a business requires energy, passion, persistence and commitment. There is no substitute for hard work and if the business was just a profit making machine surely the owner would set up more sites and just employ the staff?

The number one question that prospective franchisees want to know is, "How much will I earn?" It's a fundamental part of the buying equation and some franchisors now offer income guarantees, particularly in the service franchises. Given these types of franchises generally attract first-time business owners moving from a salaried employment position with a regular income to the uncertain world of self employment, the income guarantee can be very appealing. These income guarantees are often stated as ‘$1000 a week for the first ten weeks’ to reassure the franchisee and reduce the perceived risk of investing.

Other franchisors are offering prospective franchisees a guaranteed income of say $50000 per annum. This provides the franchisee with a degree of income stability for the first year of trading and can help the franchisee secure finance. While income guarantees might provide short term peace of mind for new franchisees, they expire and buyers need to look beyond income guarantees when assessing a franchise. What if the operator is not suited to the type of work or has no marketing skills? Generally speaking, most people looking to buy a franchise will look at least two different franchises before making a decision. You need to look at the total package including the price, training, equipment, marketing materials, ongoing fees and income guarantees. Don’t make the decision based on one part of the offering because in some instances the income guarantee is really just a recruitment incentive.

Prospective franchisees should be able to obtain enough information from the franchisor about the franchise system prior to purchase. Some areas to examine to help you make an informed decision may include:

How long has the franchisor been in business?
What are the long term goals and strategies for growth?
What qualifications and experience do the Directors and managers hold?
What ongoing support and training is provided and in what format?
What recent innovations have been introduced into the franchise?
What has been the experience of current and former franchisees?
Is the business soundly financed? You should have an opportunity to review audited financial records (preferably with assistance from your accountant)
Eventually you will want to sell or exit your franchise. Therefore it is important to understand how the agreement ends.

In summary, there are numerous issues to consider when buying into a franchise. There is no substitute for professional advice and over the years we have helped many franchisees running child care, fast food restaurants, automotive services, real estate, cafes, education, convenience stores, hairdressers and several franchisors work through the process. Contact us today about your franchise idea or purchase and we’ll show you why we are recognised as accounting experts in the field of franchising.

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Accounting for Franchises

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