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What to Do When You Find Yourself Under-Capitalized as an Emerging Franchise Brand

One of the most common mistakes emerging franchisors make is not acquiring sufficient capital, and they typically realize they are under-capitalized when it is too late. They have already created their franchise disclosure document, operations manuals, built out a corporate location or two – and have run out of capital for ongoing marketing, operational support and franchise sales.

Growing a brand quickly is one of the biggest advantages of franchising, so stalling out before you open any franchise locations or with just a few franchisees is disheartening. But, there are solutions to regaining growth momentum.

How Becoming Under-Capitalized Happens

Running out of funds starts with inadequate planning. Typically when that happens it’s because emerging franchisors underestimated the amount of time and money needed to get to royalty self-sufficiency and the point where recurring revenue covers all operating expenses.

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They also underestimate the investment required to provide the infrastructure necessary to grow even after they have sold their first 20 units. Often, they think that ongoing investment capital from corporate units will be enough to cover their cash needs. But when it is not adequate, they bleed cash from the organization while continuing to fall short of needs in their franchised business.

In other words, their growth goals are unrealistic or they haven’t properly planned for the expense of adding new franchisees. Consider, the average cost to get a signed franchise agreement done today is $8,000 - 10,000 per deal. So, if you want 10 new units, you should budget $80,000 - 100,000. If you plan on primarily using broker networks and paying a commission of $20,000 or higher per deal, your budget will be much higher.

Often, emerging franchisors only plan out enough capital to get them to the point of franchising, but fail to think about the money required to meet ongoing costs once they begin opening franchise locations. Sometimes this happens when business owners take bad advice from a franchise consultant, who convinces them that their business will make a great franchise, and for $100,000 they can get them ready to franchise. In reality, this barely covers the start-up capital required to get their documentation in order. It does not even begin to cover initial infrastructure, human capital needs or the first couple of years of franchise development advertising budgets, which could easily exceed $100,000 per year alone.

When Lacking Capital Impacts Franchisees

When emerging franchisors find themselves undercapitalized they typically start cutting expenses and limiting their support to franchisees. The latter is a slippery slope.

When franchisees can’t get the support they need, their businesses and your emerging franchise brand are in jeopardy of failing. In this scenario, you can count on having plenty of unhappy franchise owners who can prevent growth through the power of poor validation.

In addition, struggling franchisors who need the initial franchise fee to pay bills may award franchises to individuals who are not a good cultural fit for the brand or might not be good for the system in other ways, including being undercapitalized themselves.

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These franchisees, in turn, could very well prove to be the system’s Achilles heel by being undercapitalized, not following the model, providing a poor customer experience and hurting the brand reputation in the market. Franchisees who are a poor fit for any emerging franchise brand could also prove to be poor validators for the franchisor in the franchise development process, which will hinder future growth.

Emerging franchisors’ lack of capital also limits their ability to grow, which means that brand awareness and proper market saturation will be a challenge and could impact the entire franchise system. The lack of size and scale of emerging franchise brands can also impact system improvements that would come through greater brand awareness, co-op advertising dollars, purchasing power with suppliers, better margins in the business and overall efficiencies within the operation. All phases can be impacted – revenues, gross margins, efficient operating costs and net margins.

How to Re-Emerge and Grow Again

Being an undercapitalized emerging franchise brand is a scary predicament, but there are steps you can take to get the system back on its feet and growing again. It’s going to take patience and much better planning this time around.

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First, if you have franchisees, take care of them. Understand what the cash needs to run the company are at a minimum and provide an appropriate level of support to existing franchisees so that they can succeed. If the initial franchisees struggle or fail, then the whole ship goes down. It is critical that you spend the money necessary to ensure their ongoing success.

Undercapitalized franchisors will need to tighten their financial belts everywhere else, which will entail streamlining costs in their corporate units and also eliminating any unnecessary costs on the franchisee support side. It will be a long and slow process to rectify this situation, so don’t look for any quick-fix answers.

Other steps you will need to take include:

  • Review the entire system performance – corporate and franchised locations 
  • Improve sales and cut expenses where you can, but make sure not to affect customer service or product quality
  • Create a realistic proforma statement
  • Review monthly P&L statements
  • Look at ways to improve revenue
  • Find additional funding

Accessing outside capital could prove to be extremely difficult. The worst time to look for money is when you need it most and are desperate. You will also have a problem if the company is losing money as many banks and private equity firms will not look at risky deals that do not show positive EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization).

Follow the Plan to Move Forward

This time, have a realistic plan in place with proper growth strategies and firm budgets that are achievable. As you move forward again, keep a close eye on money coming in and money going out so that you don’t end up in the same situation again.

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Carefully check your P&L statements once a month – at a minimum. Many times emerging franchisors don’t have monthly P&L statements or don’t even review them.

Be sure that you are staying on your plan. If you’re not, make sure that you are making the necessary adjustments to maintain positive cash flow.

If things get tight again, take a hard look at your general and administrative expenses and see if there are areas to cut.  If you are taking a salary as the franchisor, you may need to stop and invest that money back into the business.

If things are going well, now is the time to look for additional capital so that you have enough rainy day money in the future.

With 30 years of franchising experience and more than 800 franchise owners representing over 1,250 locations for five brands, Winmark Franchise Partners can help businesses develop a sound capitalization strategy that’s right for them. Contact us here or at (844) 234-8520.