Accounting for Franchises   

Franchises are big business in Australia turning over $81 billion a year. When you buy a franchise you are basically buying someone else’s business or brand, along with all the systems, processes and marketing that comes with it. You might think it is like ‘buying a business in a box’ but it's not that simple because there are strings and legal red tape attached.

Most franchisors charge a significant start-up cost. 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. In addition, franchisees are generally also required to pay ongoing fees for support, which may be a fixed monthly amount or calculated as a percentage of gross turnover. Even though franchising is considered to be the most successful form of small business in Australia, a 2008 study 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

If you need further evidence that buying a franchise doesn't guarantee success, consider these facts. In the space of 24 hours in October 2011 close to 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 is up for sale after being placed in receivership.

Clearly it’s important to work with your accountant before starting or buying any business but the substantial up front franchise fee makes it even more important. 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 make obtaining finance difficult.

WHAT 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. For the rights to market the product or service in Australia the franchisee is obliged to pay the franchisor certain fees and royalties. 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.

GET ADVICE!

Linda McGowan, says franchise agreements need to be perused by a professional, preferably a solicitor and an accountant to ensure the franchisee understands what they are signing up for. She says, “So many franchisees don’t really understand what they are buying into and I have seen people upset when they realize that apart from the upfront joining fee there are ongoing monthly franchise costs for advertising and marketing. These were clearly spelt out in the agreement but the franchisee was so eager to buy they ignored the fine print in the contract. The whole relationship starts on the wrong foot and it is hard to transfuse the bad blood”.

Another issue is the fact that franchisees need to understand that the franchise agreement will come to an end at some point in time. The contract will probably provide options to renew but Linda says, “In any business you need to start with the end in mind. Your tax structure needs to factor in the potential discount capital gains tax concessions and you also need to consider your ability to on-sell the franchise or business to a third party plus your options at then end of each option. Franchisees who don’t do their homework and seek legal advice from the outset can be left in a vulnerable position when a franchise agreement ends.” Despite spending potentially hundreds of thousands of dollars to buy into the business the franchisees ignore the other end of the transaction, the sale. Buyer beware is the clear message from Linda McGowan who says, “I am amazed that so many franchisees tell me they were simply unaware that this could happen when it is spelt out in the contract.”

How much does a franchise cost?

As you can imagine, prices vary dramatically and you certainly don’t pay the same amount for a McDonalds franchise as you do for a Jim’s Mowing franchise. Some franchises include a large shop fit out together with equipment while others just include the bare bones.

In terms of 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. To illustrate this point, lets assume your business earnings (before interest and tax) is $100,000 before paying you a salary. If a fair salary for the business operator is $60,000 per annum then the business has an EBIT (after your salary) of $40,000. If you are looking for a 25% return on your investment then a fair price for the business is $160,000 (because a 25% return on a $160,000 purchase is $40,000 per annum).

Clearly these are 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 been established and operating
·    Whether you are buying an existing franchise or opening a brand new franchise
·    The risk associated with the industry that the franchise operates in
·    The total price being paid for the franchise business

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 be 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 be historical data and does not tell you how the business will perform in the future. Generally speaking, your projections and forecasts should be the main basis of your decision to buy a business or franchise.

Legislative Requirements

If you are thinking of buying a franchise, you should also familiarise yourself with the legislative requirements. The legislation demands that a franchisor 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 involved in establishing a franchise (at section 13)
·    Provide details of ongoing payments to the franchisor (at section 13)
·    Provide some information about financial performance (at section 19), however, franchisors can elect not to disclose any information
·    Provide a summary of the most recent financial statements of the franchisor (at section 20)

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 committment. There is no substitute for hard work and if the business was a money 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 Iearn?" It's a fundamental part of the buying equation and some smart 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 ‘$1,000 a week for the first ten weeks’ to reassure the franchisee and reduce the perceived risk of investing.

Given the economic conditions, 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 operation and can help the franchisee secure finance to fund their franchise fee. 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 when assessing the offering. 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.

In summary, there are numerous issues to consider when buying into a franchise operation. There is no substitute for professional advice and over the years we have helped many franchisees and several franchisors work through the process. Contact us today about your franchise idea or purchase and we’ll help you make an informed business decision.