One of the most pressing concerns for many franchisees is to find a way to cover the costs involved in purchasing and running a franchise, including the initial purchase, plant and equipment, premises fit-out, working capital requirements and more.
In a 2014 survey, Griffith University in Queensland found that more than half of the franchisors surveyed did not provide any form of financial assistance for franchisees. The most common form of assistance was in helping to prepare financial applications. So many franchisees can be on their own when it comes to determining how best to structure and access funding for their business.
While some costs are known and paid up front, others are incurred well beyond the initial franchise set-up. For example, equipment will eventually need to be replaced, premises may need to be refurbished or the business may need to move premises altogether. All of these activities can carry significant cost, which must be planned and budgeted for.
The answer is not necessarily as simple as getting a loan from the bank.
The key for franchisees to minimise the costs associated with these activities is to choose the right type of financing for the planned activity. All types of finance aren’t necessarily equal and franchisees may end up paying more than they need to in interest and fees if they fail to structure their financing needs appropriately.
While some franchisees may seek to avoid this issue altogether by using savings to fund purchases, avoiding both interest rates and fees, this may not actually be the best use of savings and there may be benefits in seeking finance.
Before choosing a finance instrument, franchisees need to understand three key elements of business finance.
Fixed capital versus working capital
Fixed or permanent investment capital is used for major capital expenditures such as land, building, plant, machinery, vehicles, fixtures and fittings. This is usually a long-term investment so the finance instrument should be one that supports a longer repayment period with lower interest rates and few ongoing fees.
Working capital covers day-to-day operating expenses like consumables, materials, inventory, occupancy costs and wages etc. This is usually a short-term investment because the materials and inventory should be quickly converted into sales, which then provide a return on that investment. As a result, the finance instrument can be one with higher interest rates such as trade credit or an overdraft, since the finance would be repaid relatively quickly. Unfortunately we see many business owners sit in these type of facilities for too long whereas it would be commercially prudent for them to consider other finance options.
Debt finance versus equity finance
Debt finance is usually in the form of a loan or line of credit that is repaid. The financier may use property, equipment or other collateral as security, and will charge interest.
Equity finance invites financiers to acquire a stake in the business in exchange for providing investment funds. The investor gains an equity ownership interest and, often, the right to provide input and help make decisions about the running of the business. Examples can include angel investors, who can offer their own skills and experience to help a fledgling business get up and running or an existing business to fund growth.
Depending on the type of debt finance used, franchisees can usually claim tax deductions for interest payments, lease payments, rental hire payments, or depreciation on equipment. The structure of the finance will determine what can be claimed and the timing of the claim for tax purposes.
Matching the finance to your needs
Franchisees may be better off seeking debt finance rather than equity finance due to limitations imposed by some franchise agreement. Some of the options include:
Long-term debt finance
- Finance lease - usually over a fixed term, the bank finances the lease of the equipment or vehicle and the repayments may be tax deductible.
- Operating lease - the bank finances a fixed-term rental agreement. At the end of the term, the franchisee can return the equipment or vehicle, or upgrade. Alternatively, the agreement can be extended. The repayments may be tax deductible.
- Commercial hire purchase - the bank purchases the equipment or vehicle while the franchisee makes regular repayments. Once the asset has been paid off, ownership transfers to the franchisee. This can be very tax-effective, with franchisees potentially able to claim the payments, interest and depreciation of the asset.
- Chattel mortgage - much like a mortgage on a home, the financed equipment is used as security until the loan is paid off. Franchisees may be able to claim depreciation, interest charges and transaction fees as tax deductions.
Short-term debt finance
- Overdraft - the bank or other financial institution lets the franchisee overdraw on their operating account to an agreed limit for short-term working capital needs.
- Commercial bills of exchange - this is a written, unconditional order by one party to another to pay a certain sum either immediately or on a fixed date. Commercial bills of exchange can be provided by individuals or banks.
- Trade credit - the franchisee can purchase goods on account, paying the supplier at a later date.
Before applying for or accepting any finance offers, franchisees should seek professional advice to be sure that the deal is structured in the best way possible for both tax and asset preservation purposes.
This article first appeared in Franchise Business magazine.