Sources of Funding for Franchises

By Michael Seid, Managing Director, MSA Worldwide

Since the late 1940s, franchising has served as a vehicle with which small businesses have grown successfully into national chains. Franchising has also provided individuals with the opportunity to achieve their “Great American Dream” of business ownership. Franchising will continue to be a successful strategy for those small businesses and individuals looking for prosperity and growth in the future as long as the capital required to support the strategy is available.

Outside of borrowing on the equity of their homes and their savings, friend and family or Angels are the typical backers of start-up businesses.

It is estimated that over $100 billion in seed capital is invested in businesses in the United States by friends and family. This is usually the easiest capital to raise, as the investor is making their decision largely based on a high degree of personal trust in the business owner. Investment amounts by this group generally do not exceed $1 million. These investors usually require a significant equity position, and they may also play an active role in management or on the Board of Directors.

The angel investor market accounts for approximately $80 billion in seed capital investment. This group invests approximately $7 to $10 billion dollars annually with a typical transaction size between $100,000 and $1 million. Angels are high net worth individuals who choose to invest in industries in which they have personal knowledge.

One of our start-up clients, Ecofranchising, an environmental laundry and dry-cleaning franchisor in New York, is a typical example of a company financed with Angel money.The investor, a high net worth individual from Europe, grew up in the laundry and dry-cleaning business in Austria and had prior successful business dealing with the founders of Ecomat.To date she has committed over $1 million dollars to the development costs of the company and, based upon the early results for the system, will do extremely well on her investment.

While the Angel is typically an individual, this is not always the case as Angels will often form groups who commit larger sums based on the recommendation of one of the group’s members.The Angel investor often looks for a direct role in advising the new company. This can often be an advantage for a new firm with a limited network of advisors in dealing with suppliers, landlords, advertisers and franchisees. Much of the investment decision of the Angel investor is based up their individual tax considerations, which may have an impact on the timing and the amount of the investment.

While Angels, as with friends, typically will invest in companies in which they have a personal relationship with the business owner, often the Angel market can be penetrated through referrals by firms which maintain a network of Angel investors.

One of the benefits of both the friends and family and Angel investor is in the simplicity of the investment documents, as they are less formal than those required by other sources of capital.

Many banks have now dedicated pools of funds for special interest groups and minority business people, such as that set up by Bankers Trust in New York in conjunction with the IFA for The Neighborhood Franchise Project. This program is similar to the rebuild LA program and is targeted to inner-city development. The contact person at Bankers Trust is Gary Hattem and Gary can be reached at 212.454.3487.

In addition, there are financial institutions who are willing to lend money to franchisors and franchisees if the borrower can provide suitable fairly liquid collateral to secure the lender’s debt. This type of financing is typically referred to as “asset based lending.” The assets are usually receivables, inventory or fixtures, and therefore, are typically used by product franchisors and franchisees whose principal source of income is derived from the sale of inventory. Business format franchisors who do not sell inventory to their franchisees may be able to finance equipment purchases for resale to their franchisees; however, this type of financial arrangement is becoming less common, since sophisticated franchisees prefer to purchase fixtures and equipment directly from manufacturers rather than purchase them through the franchisor.

Before I go into some more exotic financing alternatives, let me touch on another common source of capital – leasing. Often, franchisors or franchisees finance the acquisition of furniture, fixtures, and equipment by leasing them from the manufacturer or from a financial institution. Some banks will engage in equipment leasing; however, leases are typically financed through financial institutions specializing in this type of transaction. Although the funding looks like a lease, in reality it really is a method of financing the acquisition of assets. At the end of the term of the lease the lessee is typically able to purchase the property they have leased for a nominal consideration.

Franchisors and franchisees also finance the acquisition of vehicles, both automobiles and trucks, through vehicle leases. These transactions can be on an “open end” basis or a “closed end” basis. Open end leases are similar to loans with a balloon payment, where the borrower makes monthly fixed payments of principals and interest and has the option of purchasing the vehicle at the end of the term at the fair market value or an agreed amount or return the vehicle to the lender. Closed end leases, on the other hand, are a true lease where the lessee returns the vehicle at the end of the term. Often the lessors will offer the vehicle to the lessee at its fair market value, but this is the lessor’s option.

Private Placement of Equity

Most young franchisors and franchisees need at least one, and typically more than one, capital infusion in order to achieve projected growth. The most common method of acquiring such capital is through venture capitalists or strategic partners.

Financing is an essential and continuing need for any business. The degree of need and the best sources available to fulfill the capital requirements vary with the economic times and the individual company. There are, however, accepted financing rules of thumb that follow the three major stages of business development: start-up, growth, and maturity.

At start-up there are significant costs that may be incurred before any business can open its doors. This is true for the start-up franchisor as well. Some early stage franchisors have existing operations that can self-fund the design and development of their franchise system; however, the need for proper capitalization of the franchisor system is often underestimated. This leads to a working capital shortage and inevitably starts the system off on the wrong basis for both management and the franchisees. The start-up franchisor is considered to be an early stage investment by investors until there are a substantial number of units opened and the major operating flaws have been removed from the system.

The growth stage of development which follows the successful start-up can attract a high degree of interest from outside investors. Even though the franchisor has achieved a level of success, because of the costs and risks associated, investors must be convinced that growth is achievable and success likely.

Maturity may not mean financial independence. Products and infrastructure need to be constantly updated and, as markets change, so must the successful franchisor. In addition, as franchisors expand internationally, the company must have the financial resources to meet these opportunities.

The mature stage franchisor is a healthy system that still has the ability to increase corporate revenues either through further development of territories, acquisition, or company store expansion.These franchisors may also have revenue generated by product sales, which can contribute significantly to a strong cash flow for the system.

Mature stage franchisors may have already accessed the public markets during their growth stage. If this is the case, they can often use their stock as acquisition currency as they buy out competitors or augment their existing business lines with complementary franchise systems. In addition to the equity market, a strong mature franchisor will have access to traditional financial institutions that provide senior and subordinated debt financing. These sources generally are interested in transactions over $5 million, and include banks, insurance companies, and pension funds.

Loans with equity features and preferred stock usually will have future call rights to a minority position of 25% or less of the outstanding common.

Another source of capital is the Venture Capital market. Venture capital is usually defined as an equity investment in a closely held corporation by someone other than the founding group. Because the holding periods are usually between two and nine years, it is considered an illiquid form of investment. However, so that it will not be completely illiquid, there has to be the prospect of repayment via a public offering, acquisition, or a buyout of the management group or in some cases by another investor group.

The venture capital market is estimated to be approximately $40 billion, although the amount that is invested annually varies with economic conditions and is somewhat masked by what is actually raised in funds and what is actually committed the year a fund is closed.

It is important to keep in mind that large venture capital firms will see approximately 400-500 deals annually. Of these, they will seriously review 40-50 and end up investing in five to six deals. Typically, investments are $1 million and up.

The conventional wisdom is that Venture Capital investing is made up of one-third total losses or no better than break-even, one third between break-even and a return of two times initial investment, and only one third have a return greater than two times initial investment. It becomes easier, therefore, to understand that the need to access the venture industry properly requires companies to utilize experienced corporate finance and investment banking firms so as not to waste your time or theirs.

There are certain myths about the Venture Capital industry which it would be useful to understand.

• Myth One. Venture Capital is mainly seed and start-up investments. While some VCs are reviving seed-only funds, historically only 15% of capital is directed to start-ups, with an additional 18% in the first stage investment opportunities. In franchising, this stage would be when the system has launched initial franchisees but still has not proven the credibility of the concept on a national basis.
• Myth Two. Venture capitalists will insist on majority control. Venture capitalists usually have very little to say about the management team in a target portfolio company. They can insist that some members of the team be changed as a condition of their investment, but most prefer not be to interventionist. Most Venture Capital partners oversee between 8 to 18 portfolio companies and recognize the impracticality of trying to keep on top of day to day developments in all of these companies.
• Myth Three. Levels of VC funding and the composition of the VC funding are closely related to developments in the stock market. Because of the long term nature of Venture Capital investing, there is not a close relationship between VC investing and developments in the stock market. Investors will certainly look at what industry groups are in or out of favor and what price/earnings ratios have been obtained in recent initial public offerings. However, it is recognized that the market will change complexion many times before a portfolio company is ready to go public, and the same company investment may be liquefied though a merger or management buyout instead. These transactions are much less affected by developments in the stock market.

Before approaching the venture market, it is important for a company to prepare a cogent document describing the company and the reasons for the investment request. I cannot underscore enough the need for a financial intermediary in properly preparing this document and accessing the correct venture capitalist audience.

The offering memorandum should contain an executive summary and several important business sections. The executive summary should concisely define the company, its business and history, markets and growth trends in the sector, financial highlights, the investment required, and the anticipated return to the investor.

The key sections of the memorandum will further explore the company’s products and concepts. It is important to address the background of the company, the current business strategy, and product/royalty revenue mix. If the company has a mix of profitable products and is planning to launch a new line, this needs to be explained in the terms of anticipated costs and benefits analysis.

Management is always the key. Venture Capitalists are relying heavily on the track record of the company’s management to achieve their expected returns. Therefore, a successful management team with experience in franchising has a better chance to succeed in raising Venture Capital than a management team without franchising experience.

The most important focus for the Venture Capitalist will be the unit economics. It is very important, therefore, for franchise systems to capture the required information at the store level. While company-owned units can be used as benchmarks, these units are often used as testing or training centers and therefore their results may not be indicative of the typical unit. It is important therefore to capture real financial data from franchisees or company-owned stores that are not used for training and testing. It is for this reason, when we are developing or restructuring a franchise system, that a considerable amount of emphasis is placed in the MIS/POS, accounting, and reporting systems. These should also be described and included in the memorandum.

Because of the number of books the average VC firm will see in a year, it is essential that the memorandum be limited to ten to fifteen pages, plus financial and marketing exhibits. Most Venture Capitalists do not respond to overblown pieces. Concise, well written memorandums that are positioned to give them quick answers to the system’s economics and industry position will receive the proper review.

The financial intermediary’s role goes beyond just properly preparing the offering memorandum. The intermediary will help define the investment opportunity – namely why the deal is investable and how the targeted return on investment can be achieved. Another key role of an intermediary is knowing the right decision makers in the organization. They, then, are very instrumental in structuring the transaction and negotiating the final terms of the investment. Ideally, the intermediary can create an auction environment for the company where more than one venture source will be vying for the investment rights.

The timing from inception to completion of a venture transaction averages between six to nine months, so it is important to go out for funds early and not wait when a cash crunch is facing the company. It will usually take between one to two months to structure the deal, prepare the memorandum, and identify the targeted investors.

Solicitations and presentations will typically take place in the third to sixth month with letters of intent, due diligence, documentation, and closing taking place in the sixth to ninth month.

It is preferable to work with an exclusive intermediary and to carefully screen the distribution of the book so as not to have confusion and name shopping in the marketplace, as this will severely hamper and possibly damage your opportunity.

In summary, venture partners can become excellent stepping stones in equity placements. Oftentimes, a proper private equity investment with a strong venture partner is more desirable than rushing to the public markets before a system has reached critical size. When the time comes for the IPO, a well known venture shareholder can enhance the appeal of the stock.

Strategic Partners

Businesses that have an interest in a franchisee’s or franchisor’s success are often overlooked as possible investors. Franchisors should not forget that successful multi-unit franchisees have a huge stake in the expansion, growth, and success of the franchisor and may be willing to invest in the franchisor’s future or perhaps merge with the franchisor, thereby creating positive cash flow and an expanded asset base.

This is the strategy that Dan and Frank Carney applied prior to Pizza Hut’s public offering. While a successful franchisor, the system had no company owned units. By merging Pizza Hut with several successful multi-unit franchisees, Pizza Hut created a corporation with vastly larger gross sales, and exponentially larger asset base and the potential for dramatically larger profits. Through the merger, Pizza Hut became attractive to underwriters and the general public who purchased their securities, and supported the continued growth by the company.

Typically franchisees are willing to invest only if they can acquire an equity interest in the franchisor. Major suppliers, however, are often more anxious to become lenders (with warrants or convertible debt as an added “kicker”).

Leveraged ESOPS

Finally, ESOPs have sometimes been used to obtain additional capital. In effect, a leveraged ESOP is a tax advantage device for selling common stock of a company to a trust owned by the company’s employees.

The ESOP Trust, established for the benefit of the employees, borrows money from a bank, usually for a five to seven year term, for the express purpose of purchasing shares of the company’s stock from the company. The price paid by the ESOP trust is determined by an appraisal with the company guaranteeing the repayment of the ESOP’s debt to the bank.

Each year the corporation makes a contribution to the ESOP Trust which the trust uses to repay the bank. Under present tax rules, the corporation receives a deduction for the annual contribution it makes to the ESOP Trust.

The result of the foregoing is that the company is able to sell a substantial amount of its common stock to a trust for the benefit of its employees and is able to finance the ESOP Trust’s purchase through a tax-exempt contribution to the trust.

The success record and stability of franchising is increasingly appreciated by institutional and other sophisticated investors and lenders. Franchising has become an acceptable alternative investment strategy for investors because it meets or exceeds their target returns. With an understanding of the franchise dynamics, they now appreciate how it can meet their performance requirements and, with proper guidance, franchise systems are navigating the acquisition of equity or debt sources successfully.