A majority of banks and financial institutions still lack an understanding of the concept of franchise funding. In order to highlight its importance some top leaders in the industry have explained its significance
Whether you are an existing or prospective franchisor or franchisee, funding a new venture or pumping in money for existing ones requires capital resources.
And arranging for the money needed to finance a franchise business continues to be a challenge for most entrepreneurs in India.
Though India offers good human resources, but these people might not necessarily have the capital resources required to take up franchisees. On the other hand, those equipped with adequate capital resources might not have the qualities required for running a franchisee. Due to a basic lack of understanding of the concept of franchise funding, this gap has not been bridged so far and can act as a losing proposition for franchisors.
While poor management is frequently cited as the reason most businesses fail, inadequate or ill-timed financing can also lead to dire consequences. Also, capital planning is required to manage the resources effectively to ensure that entrepreneurs do not secure the wrong type of financing, miscalculate the amount required, or underestimate the cost of borrowing money.
An established franchisor may be able to leverage his track record to set up semi-automatic financing for new franchisees. These can be either leases or loans that are provided primarily because of the success of the franchise system. Incidentally, in India, funding franchisees is viewed in the same bracket as funds made available to any prospective entrepreneur who has a good brand name associated with him.
The nature of business largely determines the kind of investment that it would require. Most franchisees need funding right from the start to cover the costs associated with acquiring a franchise business. ‘Fixed capital’ is needed to cover fixed costs, such as the initial franchise fee to the franchisor and any additional set-up costs. A certain amount of ‘working capital’ is also needed to cover operating costs. There may also be an ongoing management fees to be paid to the franchisor. Unlike other small businesses, franchising involves intangible assets, such as franchise fees and licencing costs.
You also need to determine whether these costs are essential or optional. A realistic start up budget should include only those things that are necessary to start the business. These essential expenses can then be divided into two separate categories: fixed and variable. Fixed expenses would include rent, utilities, administrative costs and insurance costs, while variable expenses would include inventory, shipping and packaging costs, sales commissions, and other costs associated with the direct sale of a product or service.
Once these costs are identified, you need to calculate the amount of funds available with you. Following this, you need to estimate the amount of money that would have to be sourced from outside.
It is important to understand the requirements and needs of the lender and be realistic about what can be accomplished. A lender is looking for factors that will reduce the risk associated with the loan and the more you can offer in this area, the easier it will be to get the loan. In general, the lender is looking at four factors: character, credit, cash and collateral.
Types of financing
There are basically two kinds of funding: direct and indirect. Under direct financing, the franchisor funds the franchisee, while in case of indirect financing, third parties undertake the financing. In indirect financing, money can be generated either through banks or some private financial organisations or friends and family.
You should consider your sources of finance carefully because each one will have its own pros and cons. For instance, if you were to use your savings to start out as a franchisee, the cost to you is the lost opportunity of investing the money elsewhere or the security of having it in the bank. Similarly, a bank may be willing to lend the necessary funds but this will usually be against some kind of security, such as your personal assets.
Among the available options, what suits the best to the franchisee varies from individual to individual. The financing option should ideally be chosen depending upon the nature and amount of investment required. Says Mr Ashwini Aggarwal, country marketing manager, HP, “Typically, small format retail franchisee generate funds for themselves while the working capital is funded through a bank.”
Mr Martin Francis, senior franchise manager, HSBC says, “What is distinctive about the franchisee proposition is the fact that depending on the nature of the franchise, the proportion of the start up costs and working capital that can be financed by the bank, is typically in the range of 50 to 70 per cent rather than the 40 to 50 per cent normally seen.”
Internationally, a number of franchisors finance their franchisees. This is because, in a young system, usually large amounts of economies of scale are required.
In India, direct financing by the franchisor is still not widely practiced. Says Ms Heena JA, COO, Travelport, “We do not have the practice of franchise funding. In case of franchisor funding the franchisee, the franchisee does not feel the pressure of performance as his money is not at risk.”
This opinion is reaffirmed by Mr Manpreet Gulri, Subway, “Currently, banks and personal contacts are the only options available to our franchisees. Either option can be suitable, depending on which offers them the best interest rate and other terms and conditions.”
Similar views are echoed by other franchisors. Says Mr Aggarwal, “HP does not fund the franchise directly. However, its retail programme covers issuing of merchandising fixtures, signages and other branding elements at highly subsidised rates that lower the franchisees overall investment dramatically.”
The international scenario
Over the years, franchising has come to be regarded as an inherently safer method of starting a business rather than setting up a completely new venture. As such, banks and lending societies tend to look favourably on potential franchisees. The usual arrangement is to have a loan for the fixed capital needed and an overdraft for the working capital. Also, with a number of franchisors providing proper backing to franchisees, banks are more secure when lending large amount of money for startup costs. The proven profitability along with established trademark and goodwill, as well as marketplace experience of many franchisors also helps. Studies have also revealed that franchised businesses generally experience lower default rates than independent businesses.
To aid franchisees, the Small Business Administration (SBA), US, an independent agency of the executive branch of the Federal Government, provides financial assistance for entrepreneurs, including franchisees. Community development organisations can also get the government's full backing on their loan to finance a portion of the financing needs of franchisees.
In UK, franchise funding is offered by banks like Natwest, HSBC, Royal Bank of Scotland and Lloyds TSB. All four have dedicated franchise sections and are accredited by the British Franchise Association.
Natwest was amongst the first banks to recognise the potential of franchise financing by appointing UK's first franchise manager in 1981. The bank now has over 100 area franchise managers across the country, and over 1,600 outlets that deal with franchise-related enquiries. Natwest offers up to 70 per cent of the total start up or entry costs to new franchisees. For well-established franchises, the bank offers significant working capital. These loans are expected to run over the lifetime of the franchise agreement, which is usually five years. The bank offers a ‘capital repayment holiday’ of 6 to 24 months on some loan products. In this period, franchisees are only required to pay the interest charged to them, rather than the loan amount itself.
Royal Bank of Scotland (RBS) offers a wide range of services to support franchisees. Their franchise development managers are assigned to franchisees for at least three years and deliver expert advice and support. The bank also refers franchisees to accountants and solicitors with experience in this sector.
The main financial package that RBS offers is similar to Natwest's. Franchisees can receive up to 70 per cent of their startup and operating costs with the repayments linked to the term of the franchise contract. RBS also provides case studies on those who have taken up franchising and gives information on franchise exhibitions and seminars.
Lloyds TSB also has a dedicated franchise team to help a franchisee start and run a new business. The bank also offers free access to its franchise database.
HSBC operates on the same lines as Natwest. Tthe bank has a dedicated franchise team available throughout the year, and provides valuable advice to potential franchisees. The bank provides specialised franchise loan, which is designed to finance the purchase or expansion of a franchised business. It offers flexible terms, including the option of fixed interest rates and capital repayment holiday for certain loans.
There are about 27 public sector banks, 31 private sector banks and 29 foreign banks in India today, but most of these banks do not have any well-defined policies for franchising.
HSBC is amongst the few banks that view franchise financing as a specific lending market within the small and medium enterprise (SME) segment. Among the attractions that the segment offers are improved risk or return equation, range of business types and a well defined target market.
Says Mr Martin Francis, HSBC, “We perceive franchise financing as an opportunity for the bank to grow its business with the SME segment in India. Franchisees replicate a successful business model and are usually more successful than stand-alone SMEs. The bank, therefore, views franchise financing as a relatively lower risk way of tapping the SME market.”
Says Mr U S Bhargava, GM, retail, India, Punjab National Bank, “We usually have agreements with franchisors so as to simplify the procedure of getting a loan. We have tied up with Apollo Clinic, Dr Lal's clinic, Nirula’s and so on. At the same time, finance is available for other franchisees as well. As it is safer to fund franchisees, we can reconsider the rate of interest and also lower the margin.
For SME's, we finance up to 75 per cent of the total amount while for franchisees this can even be up to 80 to 85 per cent.”
ICICI Bank forayed into franchise financing about two years back. Says Mr Kumar Ashish, DGM, head business banking, SEG, ICICI, “Franchisees are a part of the large retail setup, so our specialised retail department handles this sector as well. One way of extending loans to franchisee is to tie up with the franchisor and take over the task of funding its franchisees. In this case the business model is already approved so it simplifies the procedure. Another approach is when the franchisee himself contacts us for a loan. In this case, we look at the sustainability of the venture or the past performance of the franchisor, the profits made by the franchisor so far and the future prospects of the project.”
Though banks might not always value ‘brand’ as an asset, since the key focus of their analysis is the ability of the business to meet its financial obligations. However, they do value brand power. “We would take into account the strength of the brand as part of our assessment of individual lending requests and the perceived strength of the franchise system influences the percentage of the investment costs that the bank may be willing to finance,” says Mr Martin.
As a result, banks make the processing of loans easier. Says Mr Ratan Jalan, CEO, Apollo Health and Lifestyle Ltd, “Recently we have signed a memorandum of understanding (MoU) with State Bank of India (SBI) to facilitate the financing of our franchisees across the country. SBI has the largest network and therefore, acts as the best option to do so. This MoU would ensure that our franchisees get privileged treatment in terms of processing formalities as well as terms of the loan. We have also had dialogues with quite a few leading banks such as Punjab National Bank and Jammu & Kashmir Bank. These banks have also approved our business model.”
Getting a loan becomes much easier for a franchisee if the franchisor has a tie up with banks. “No matter how strong a brand is, there is always some sort of vulnerability. As a result, the bank is much more comfortable funding a franchisee if some sort of assurance is provided by the franchisor,” explains Mr Ashish.
Loans to small businesses require 100 per cent security, whereas loans to franchised businesses, are usually made on normal lending terms. As such, lenders are willing to offer different levels of financing and terms to franchisees of different systems seeking financing on otherwise identical deals. Ms Heena says, “Currently the mechanism to fund the franchisees is helpful to those who have assets to back it up. The banks do not fund lesser-known companies easily.”
In deciding whether to extend a potential franchisee a loan, the bank uses criteria that are the support system for franchisees. For example, the bank will want to know what level of support the franchisor will provide in marketing, advertising and equipment packages as, more the support extended to the franchisee, more the chances of survival. The bank would also want to look at the sales projections for new locations of the franchise and averages for existing locations. “We need to be satisfied with the reliability of financial statements as well as levels of profitability and promoter’s stake. And only after we are completely satisfied, we extend a loan,” says Mr Martin.
Yet as far as defining any franchise concept is concerned, the specifications and technicalities are far less professional as compared to international banks. As per Mr Gulri, “Our parent company is following a customised practice for funding their franchisees in the US and in some other countries across the world. A leasing corporation to do the same has not been set up as yet in India, but hopefully one will be in place very soon.”
This clearly indicates that though the concept is gradually gaining acceptance, India is yet to implement it wholeheartedly. While franchising is seen as a more stable method for starting up, that does not mean that a bank manager would not refuse the application for a loan. According to officials at Citibank , “Franchisees fall in the same bracket as SMEs for us. Loans are structured according to the viability of the project and credit worthiness of a person. We usually do not invest in a volatile industry.”
Challenges faced by the sector
Though banks finance a part of the capital requirement and also have the facility of financing the working capital, yet the franchisee fee has to be funded by the franchisee himself. Says Mr Bhargava, “We do not finance the franchisee fee because looking at the Indian market it is rather unsafe for a bank to do so. If a franchisee fails, the assets can be sold and the basic funds can be recovered but the fee cannot be recovered.”
There are other areas of concern facing banks funding the franchisees. Says Mr Jalan, “There are a couple of concern areas, which, if addressed, will make it an ideal option for funding. Several banks do not regard one time licence fee as a part of the project cost and hence, exclude it while computing loan eligibility limits. Also, banks do not take into account several components like the cost of interiors, in funding. Since maximum franchise opportunities exist in the retail segment where these costs are quite high, this can pose a problem.”
Mr Aggarwal feels, “Services are growing but we have yet to see the evolution of ‘easy’ finance for franchisees. The reason is that retail till recently was an unorganised sector and project funding was a high-risk investment for most institutions at such a micro-level.”
Funding options available for franchisees are still at a very nascent stage of development. There is a lack of knowledge amongst funding organisations and also a lack of acceptance. With international funding organisations and banks setting up an exemplary model and the obvious advantages that funding franchisees has, the change, would soon be reflected in the Indian mind-set as well.